The document discusses the impact of mandatory central clearing of over-the-counter (OTC) derivatives on costs and the derivatives market. Central clearing of OTC derivatives has increased costs for market participants due to higher capital charges, margin requirements, and collateral costs. It has also led to a shift toward clearing standardized products and away from bespoke hedges. Firms are focused on optimizing their collateral and improving collateral management processes to help offset these increased costs. Regulations continue to evolve in ways that will further shape the OTC derivatives market.
The future of the OTC Derivative Market - Eugene stanfield
1. The future of the OTC Derivative Market
The impact of Central Clearing
2. 1
Agenda
Impact of mandatory central clearing on OTC derivatives
Cost of doing business
Collateral management efficiency
Regulations still to shape how we do business
3. 2
Impact of mandatory central clearing on OTC derivatives
Source: Statistical release – OTC derivatives statistics at end-December 2014, April 2015, Bank for International Settlements
Gross market value drops significantly post 2008 crisis
Trading becoming increasingly capital-intensive
Clearing, trade compression and netting gaining importance
Recent trends in OTC derivatives market
Dec 12
585
Dec 11
596
Dec 10
553
Dec 09
532
Dec 08
525
Dec 07
508
Dec 06
361
Dec 05
257
Dec 14
598
Dec 13
676
CDSFXInterest rate
Notional Principle (USDbn)
Dec 10
19
Dec 09
18
Dec 08
29
Dec 07
11
Dec 14
19
Dec 13
17
Dec 12
22
Dec 11
24
Dec 06
7
Dec 05
7
Gross Credit ExposureCDSFXInterest rate
Gross Market Value & Gross Credit Exposure (USDbn)
4. 3
What is the impact of the regulations on OTC market?
37% believe OTC liquidity has deteriorated over the past years
54% still consider derivatives crucial for efficient risk management
67% believe reforms won’t impact their demand for derivatives
Source: ISDA Insight (a survey of issues and trends for the derivatives end-user community); April 2015.
Impact of mandatory central clearing on OTC derivatives
What are firm’s biggest concerns regarding
ability to use derivatives to manage risk?
0%
10%
20%
30%
40%
50%
60%
70%
Increased
costs of
hedging
Uncertainty
about
regulations
Concerns
about cross-
border
derivatives
regulations
Few er
dealers to
transact w ith
Reduced
availability of
hedging
products
Not able to
handle
clearing
Not
sure/other
5. 4
62% expect more OTC derivatives to be centrally
cleared
17% believe more than 30% of their transactions will
remain uncleared
Source: the Global Survey conducted by Risk and IBM. Risk Magazine, May 2014
2015: 65 % of IRS and 29% of CDS outstanding
notional is centrally cleared
What are the firm’s expectations on cleared transactions?
Impact of mandatory central clearing on OTC derivatives
Currently being
centrally cleared
Expected to be centrally cleared in the next
two years
0-25% 25-50% 50-75% Total
0-25% Buy-side 10% 19% 9% 38%
Sell-side 10% 15% 12% 37%
25-50% Buy-side 2% 2% 4%
Sell-side 5% 5%
50%+ Buy-side 6% 6%
Sell-side 10% 10%
Total 19% 36% 44% 100%
Maintain cleared % Increased cleared %Key:
Desire to clear vs Requirement to clear!!
6. 5
Source: BIS report - Regulatory reform of OTC derivatives: an assessment of incentives to clear centrally. October 2014.
Collateral costs
Capital costs
Initial margin requirement
Default fund requirement
Default fund exposures capital charge
Trade exposures capital charge
Initial margin requirement
CVA risk capital charge
Counterparty default risk capital charge
Central clearingBilateral trading
Cost of doing business
Costs of central clearing vs non-cleared – USD1m 5 year IRS
Breakdown of cost components for a stylised example
Bilateral Trading Estimated cost example (USD) Central Clearing
5,000 Potential future exposure 5,000
700 Total collateral required (initial margin + default fund) 572
80 Counterparty credit risk 8
310 Credit valuation adjustment n/a
n/a Default fund capital requirement 72
-11 Offset for initial margin received (for bilateral only) n/a
379 Total capital required 80
Costs
5 Cost of collateral (0.7% x total collateral required) 4
25 Cost of capital (6.7% x total capital required) 5
30 Total costs 9
7. 6
1The leverage on a portfolio level is calculated differently from PFE at trade level. It recognises hedging at netting set level by net gross ratio.
Cost of doing business
What are LCR costs for Clearing Brokers?
LCR-implied costs
Maturity [yrs] 0 - 1 1 - 5 5 - 10 10 - 20 20 - 30 30 - 40 40 - 50 Total
Notional sum [m €] 1,400 1,438 971 352 119 43 16 4,339
Risk Add-on 0.0% 0.5% 1.5%
=
€30m
A gross
€ 13.5m
= 0.4 x
€30m
+ 0.6 x
0.09
x
€30m
PFE A gross NGR1 A gross
€ 0
+
€13.2m
+
€13.5m €26.7m
x
4% €1.07m
x
12% €128k
Current
exposure
IM + 20% addn
collateral
PFE LR exposure LR
Required
capital
ROC
Required
return
Leverage Ratio ~ 0.3bps on total notional
8. 7
New capital charges drive costs higher for all
OTC derivatives but particularly for non-cleared
derivatives
Focus shifts towards the futures market thus
compromising on the hedge’s bespoke nature
End-users opting for non-perfect hedges
(increased demand for standardised products)
Operational complexity is leading to investment
into collateral and processing set up
Firms to restructure product offerings and
pull back from too costly asset classes
Careful selection of one or two CCPs to
maximise netting benefits and reduce
costs
Market is developing standardised
approaches to model margin
requirements
Cost of doing business
What will the OTC market look like post-reform?
9. 8
Collateral value chain
Need to understand bilateral & cleared margin requirements
Solutions to facilitate margin calculations & asset segregation
Enhanced mechanisms to track collateral & its beneficiaries
Configuration to support the re-hypothecation requirements
Multiple custodians connectivity to manage cash & securities
Central
clearing
Mandatory clearing coverage to grow
Bilateral
margining
Complex and Illiquid market with high
margins
Collateral value chain
Optimal Counterparty Choice Efficient Margin Management Optimal Allocation of Collateral
CCP
Bilateral counterparty A
Bilateral counterparty B
Cross product margining
Netting & compression
Backloading
Holistic approach
Collateral substitution
Automated collateral
processes
Pre trade Continuous Post trade
Collateral management efficiency
10. 99
Need an overarching approach to risk management
Alignment of disjointed collateral management
essential
Investment in infrastructure and technology is expected
Demand for eligible collateral to increase
Collateral upgrade and transformation gaining
importance
Capital, balance sheet and liquidity management
critical
Increased interconnectedness of previously distinct considerations
Collateral management efficiency
Inventory
Optimisation
Operational
Execution
Organisational
Set-up
Infrastructure
/ Technology
Resource
Management
Trading
Strategy
Balance
Sheet
RWA
LCR
LR
11. 10
Documentation management platform
Sungard
Accenture
Markit
KYC utility
DTCC
(Static Data)
Genpact
TCS -Bancs
Clearstream
Broadridge
CAPCO - FIS
Euroclear
Bank Consortium
(Static data)
WIPRO
IBM
Growing importance of third party providers
New utility set-up emerging from the collateral paradigm shift
Collateral management efficiency
Repo Desk
Sec Lending
Derivatives
Treasury
Operations
Collateral management function
Sec
Lending
Repo F&O Treasury…
Markets/FO businesses Regional treasuries GT, …
Collateral
Optimisation platform
Eq Fl FX
Commodities
Cash
ListedandOTCderivatives
Governance
Product lines
Legal and
documentation
Collateral users
Traditional collateral setup Emerging trend
Markets/FO businesses Regional treasuries GT, …
MNA…ISDACSAGMRA
Source: Oliver Wyman, “Collateral Management Perspectives, September 2014
12. 11
Current issues
Leverage ratio =
Tier 1 Capital
Total Exposure ≥ 3%
January 2018
implementation
Proposed changes on leverage ratio
Regulations still to shape how we do business
1. BCBS drafting a FAQ document to address the margin issue.
2. Market expects segregated client IM to be exempt from LR Replacement Cost but IM offsets to remain.
3. PFE add-on likely to be calculated with the method in place.
What are
next steps?
Exposure-reducing effect of IM not recognised1
PFE add-on (driven by total notional) jeopardises porting between CBs4
IM an on-balance sheet asset & part of Total Exposure – significant extra-burden2
Banks argue for this to change as client assets are segregated from bank’s own
and not available for re-use
3
13. 12
MiFID II/MiFIR – all-encompassing impact on your organisation
Transparency
Investor Protection
Organisational
Requirements
Position Limits
OTC Derivatives &
Commodities
Market Structure
Non-discretionary
access
to venues
Trading of derivatives
on RMs
SME markets
introduced
Rules for Systematic
Internalisers
Specific capital/reporting
requirements
Electronic execution of
certain derivatives
ESMA to draft technical
standards
Pre/Post trade transparency Trade reporting to the authorities
Best Execution
Key Information
Documents (KID)
Client money/asset
rules
Client classification
Better risk controls for algorithmic
trading
Enhanced Governance
Position limits on commodity
derivatives
Position Reporting
Firms should review their client base and how MiFID II impacts their way for doing business with these clients
Significant changes to operational processes – including IT systems updates – required
MiFID II/MiFIR – key areas
Regulations still to shape how we do business
14. 13
Source: the Global Survey conducted by Risk and IBM. Risk Magazine, May 2014.
What BCBS/Iosco requirements are ranked as being
most difficult?
How prepared are you to calculate and post initial
margin on a gross basis?
BCBS/IOSCO requirements are ranked as being most challenging*
Regulations still to shape how we do business
26%
18%
10%18%
14%
21%
0% 10% 20% 30% 40% 50%
Initial margin
modelling
Group level
initial margin
threshold
Managing
restrictions on
rehypothecation
Buy-side Sell-side
Buy-side Sell-side
7.7%
61.5%
30.8%
12.2%
40.8%
46.9%
Well-prepared to calculate IM
On track and expect to meet the requirements
Concerned about requirements
15. 14
Limited time between the determination of whether parties are in scope and the mandatory compliance.
Major business, operational, legal and technical changes need to be addressed.
What are the implications of BSBS/IOSCO margin requirements?
Regulations still to shape how we do business
Gross IM to impact firm’s liquidity, funding, systems and legal documentation
New infrastructure needed to support daily margining
Application scope
Various internal models can receive regulatory approval
Disputes when non-standard internal models used – risk implications
Calculation methodology
Demand for and costs of eligible collateral likely to increase
Firms to focus on collateral optimisation/transformation
Eligible Collateral
Increased funding requirements due to gross IM exchange
Changes to existing ISDAs/CSAs
Re-hypothecation
Implications for firmsKey areas
16. 15
Markets not waiting for rules to be finalised and are adhering to the rules on a voluntary basis
The paradigm is shifting
Summary
Margining and collateral management at the forefront of clients’ attention
Need for a holistic, centralised approach to collateral optimisation and management – substantial investment
Chose carefully providers capable of facilitating your collateral needs throughout the collateral value chain
Liquid and eligible collateral crucial for doing business – collateral substitution and transformation to gain importance
OTC market increasingly expensive – shift towards futures expected