Presentation given on 1st March at a joint PRMIA/ISDA event in London on 1st March 2012 on the "The Future of OTC Markets"

1. The Future of OTC Derivative Markets
A brighter/bleaker future for risk managers
John Wilson

2. John Wilson
• Former Global Head of OTC Clearing & MD at RBS
• Led the formation of the OTC clearing business and
subsequent development of the clearing solution for
House and Client Services
• Prominent role in the development of end user
services at many international CCPs
• Led sales efforts with international client base and
provided advice to many key accounts on the impact
of clearing and related regulatory changes
• Close involvement in the global regulatory debate and
frequently represented the industry in Governmental
meetings on regulatory change
• See http://uk.linkedin.com/in/johndwilson

3. Contents
Drivers for OTC market evolution
The Future of Trading and Clearing
CCPs: Financial Nuclear Power Stations
Collateral Wars
Cross border tensions

4. Drivers for OTC market evolution

5. Financial Crisis
• Financial Crisis in 2008/9 highlighted structural weaknesses
including
– Absence of regulatory transparency on positions or activity in OTC
markets
– Lack of collateralisation in some notable instances
– Inter-connectedness of financial institutions
• Policy makers have also claimed
– Dealers were making unreasonable profits from opaque markets OTC
– OTC derivative prices and capital charges did not fairly reflect their
social cost
– “Casino banking” is a material threat to retail banking arms
– Markets were distorted by the proprietary trading arms of banks
– Actions of financial speculators caused harm to the real economy
– Counterparty risks present systemic risks to the financial system

6. Regulatory landscape
• G20 Group Meeting in Pittsburgh in Sep 2009
“All standardised OTC derivative contracts should be traded on exchanges
or electronic trading platforms, where appropriate, and cleared through
central counterparties by end-2012 at the latest. OTC derivative contracts
should be reported to trade repositories. Non-centrally cleared contracts
should be subject to higher capital requirements”
• Regulatory framework agenda to meet these objectives
– US Dodd–Frank Wall Street Reform and Consumer Protection Act [“DFA”]
– EU European Market Infrastructure Regulation [“EMIR”] & MIFID2
– Basel III [EU implementation - CRD IV]
– Japan has enacted legislation requiring clearing by end 2012
– Singapore to mandate clearing but not “Exchange” trading
– Other regions/countries developing their regulatory proposals including Hong
Kong, Australia & Canada

7. Bank Regulatory Pipeline Overview
Not exhaustive, just exhausting!
Equity Market
Infrastructure
Securities Directive
OTC Derivatives –
Trading Platforms
Interest Rate Risk – OTC – Infrastructure
Banking Book
Non Equities Price
Transparency Short Selling
Fundamental review of
trading book Market Abuse Securitisations
OTC – Capital
US Banking Market Risk
External Credit Ratings Reform
Leverage Large FSA liquidity
Exposures framework
Structural Capital Remuneration
Separation
UK Bank levy
Resolution
Systemic Banks
Cross-border funding IGL restrictions
restrictions Recovery
EU Bank Levy
Supervisory
Basel Liquidity Architecture
EU Crisis Management Procyclicality
Regulations in final stage
Regulations in early stages of policy setting – Actual
of policy setting – Impact impact and mitigation
and mitigation, Initial steps numbers, appropriate
Regulations in early stages of discussion or
in external engagement external engagement
not yet identified – Regulatory Intelligence

8. “The Bigger Picture” for buyside
Source: Tony Kirby, E&Y

9. Capital requirements
• Policy makers are determined to increase the cost of using OTC derivatives
• RWA levels incentivise cleared over bilateral exposures, notwithstanding
some products cannot be cleared
• Capital costs for clearing members will increasingly prompt re-evaluation
of business case and cause a polarisation of the clearing market
– Default fund
– Market risk charge on accounts failing to pay margin same day
– Capital linked to initial margin
• New capital charges reduce bank capacity and widen spreads, but
encourage new entrants unfettered by capital charges
• Banks will be motivated to unwind existing stocks as part of deleveraging
efforts

10. Trading & Clearing obligations
• Mandatory clearing will apply to
– Trades between financial institutions,
• EU has granted exemption to Pension Funds trading with EU counterparties for up
to 6 years and to intra-group trades within EU
– Corporate groups in EU which exceed usage thresholds
– Third country sovereigns
• Key factors in an instrument being capable of being cleared
– Standardisation [product, legal, process]
– Liquidity
– Risk management/modelling
• A mandatory clearing obligation will normally create a mandatory trading
obligation, with the exception of block trades in the US

11. Instrument scope for clearing
• Regulations have yet to prescribe specific instruments
• Clearing exemption in the US for FX Swaps and FX Forward, EU position yet
to be determined
• Expect the following instruments to be cleared
– Plain vanilla IRS, Inflation swaps, Cross Currency Swaps, Swaptions
– Index CDS [index tranche less likely]
– Some single name CDS [high-grade, rather than high yield]
– FX Options* [CCP must guarantee settlement of gross amounts to all parties]
– Non-deliverable FX forwards
– OTC Equity options
– Commodities

12. The Future of Trading and Clearing

13. Trade universe
The relative dimensions of the quadrants will vary by asset class and
product, as well as by turnover v tickets
Product can’t be
Party exercises SEF & Bilateral & cleared; or No
exemption from Not Cleared Not cleared requirement to clear;
clearing but chooses or Party exercises their
to use SEF exemption from
SEF &
Cleared clearing and SEF
Product obliged to clear
Bilateral & but either no SEF or not
mandatory cleared mandatory to use a SEF
Product requirement to e.g. block trade
clear & use SEF; or Bilateral & Product can be cleared
Party disregards their voluntarily cleared but not mandatory to
exemption from clearing
use clearing or a SEF; or
to both use SEF and clear
Party voluntarily clears
but trades bilaterally

14. The OTC Execution Venue
Platform routes RFQs /
Client A Platform routes RFQs/ Orders
Orders / Streamed prices Dealer X
Client A Exchange Dealer X
Client A Dealer X
Client A Platform Dealer X
Party
Client A
Party B
A
Post trade process varies by
SEF model
Party A
Gives Up to Clearing B self
Clearer clears
ABC House

15. Trading
• Few products will be suitable for clearing and hence exchange-trading
• Clearing is a credit leveller – all counterparties face the CCP and not each
other shortly after execution and enable pre & post trade anonymity
• Pre & post trade transparency like equity & futures markets, but expected
to impact liquidity and discourage firms from making markets in size
• Growth in traded notional and transaction volumes, with electronic
trading also widening market participation
• Fragmentation of liquidity across myriad of venues and across CCPs, with
multiple market models operating in parallel including voice
• Regional trading & clearing arrangements due to regulatory barriers
• Capital costs of bilateral trades drives down volumes for non-cleared
trades

16. Trading
• Significant organisational change for dealers
– Clearing function required to be independent of “Sales & Trading”
– OTC market will move to an agency sales model for “exchange” traded
products, most probably commission based
– Market making by dealers likely to diminish as spreads tighten, profitability
weakens, inventory risk increases and capital burden grows
– Rules that inhibit proprietary activity e.g. Volker, will preclude market-making
activities in certain entities/products, will entail closing or transferring
functions
– Increasing spend on technology arms race as for other products, with some re-
use of technologies

17. Prospective SEFs
The new regulations have created new commercial opportunities that many firms are
seeking to exploit. This “big bang” is likely to be followed by a “big crash” with firms
exiting or consolidation occurring, reflective of liquidity in asset classes concentrating
around a few “winners” that capture most of the liquidity. A similar pattern occurred in
other asset classes such as equities and futures.
• BGC Partners, Inc. • MarketAxess
• Bloomberg, LP • NASDAQ OMX
• CME Group • Nodal Exchange
• Creditex • NYSE Euronext
• Ederiv • ODEX
• Eris Exchange • Parity Energy, Inc.
• FXall, Inc. • Tradeweb
• GFI Group, Inc. • Tradition North America, Inc.
• ICAP • Trumarx
• Intercontinental Exchange • Tullett Prebon
• Javelin Capital Markets, LLC • Thomson Reuters
• LSE

18. Opportunity for “Smart aggregators”
• Pre “Big crash”, fragmentation creates opportunities for firms to provide
consolidated/aggregated views across markets, accompanied by smart
routing of orders to the “best destination for a given order.
• Smart aggregators/routers already exist in equities, futures and FX and
typically provide
– Holistic views over venues to provide depth and price data on a consistent basis
– Routing facilities that provide connectivity to multiple venues on a
• Simple basis with the user determining the venue
• Smart basis with the router determining the venue
• Algorithmic basis, with the router determining how to slice and distribute orders across venues
to achieve a balance of speed, best price, minimal market impact
– Some venues will not provide users will direct access but insist that there access is
“sponsored” by a venue participant/member, and may require orders to be routed via
the sponsor rather than submitted directly
• Smart aggregator tools will proliferate but may struggle to cope with some
market models e.g. RFQ v CLOB

19. Clearing
• There will initially be many CCPs competing around the globe, but
regulations will hamper global CCPs
• Few CCPs will achieve critical mass, prompting consolidation but progress
will be slow and inter-operability will take many years to come to fruition
• CCPs will compete on
– Cost
– Lowest initial margins, offset by larger default funds
– Widest range of eligible collateral and liquidity facilities
– Segregation facilities
– Cross product offsets for margin purposes e.g. listed v otc
• Huge tension with members over default funds, due to likely capital costs
• Convergence of CCP risk models through regulation and member pressure
• Onboarding the industry represents a massive challenge

20. The end user dilemma
Clients using derivatives will face a choice:-
• Hedge effectively, and accept the higher cost it will entail; or
• Buy a standardised derivative hedge that is cheaper, but remain exposed
to basis risk (and loss of hedge accounting treatment)
• Opt not to hedge via derivatives
End Users: The Options
Choose bespoke OTC-traded Choose standardised Choose not to hedge through
Derivative Derivative Derivatives
• Increased costs through • Basis risk assumed by client • Non-business risks assumed
additional capital passed on through difference between by client (earnings
to client either via OTC price actual risk and standardised volatility/mandate issues)
and margin/collateral. product
• Management of market risks
• Cost of hedge vs. exchange • May have accounting moved from bank to client
traded derivative higher. implications
• Cheapest upfront costs for
• Non-business risk passed to • Management of market risks clients
bank where it can be better moved from bank to client
managed. • Cost of hedge to client is
lower vs. OTC derivative

21. Counterparty exposures
Category Default treatment Collateral treatment New rules on netting sets
(A) - Offset with (C) Would not need to be are likely to exacerbate
Historic collateralised for initial
trades margin, only mark-to-
counterparty exposures
market on the basis of
existing Credit Support
Annex terms. Netting of
variation margin
requirement with (A)
(B) - Remain as a separate Would attract initial margin
Cleared netting set per CCP and requirement from the CCP
trades per product, with the and have a cash variation
portfolio and related asset margin requirement, purely
either being transferred to on cleared trades, with
a new clearing firm or separate netting sets per
being liquidated CCP and product
(C) – Offset with (A) Would attract initial margin
New non- requirement. Netting of
cleared variation margin
trades requirement with (A)

22. Transaction reporting
• Onset of new data requirements to support
– Legal entity identifiers [“LEI”]
– Product identifiers [“UPI”]
– Transaction identifiers [“USI”]
• Onerous reporting responsibilities to satisfy aggregate requirements from
many jurisdictions, which are not necessarily consistent in scope or
content or format
• Multitude of competing trade data repositories with a regional bias likely
and with duplicated reporting to be a common occurrence
• Complex reconciliation processes will be required to ensure consistency
between own records and regulatory repositories
• Eventual migration from transaction reporting to position reporting to risk
reporting but the latter of which struggles with cross-asset offsets

23. CCPs: Financial Nuclear Power Stations

24. CCPs – The Financial “Nuclear Power” Station

25. CCP Default - Too big to Fail?
• Paul Tucker, deputy governor of the
Bank of England and Head of FSB group
on CCPs, said the issue needed
attention because clearing houses had
become centres of systemic risk in their
own right, with potentially huge
consequences in the event of failure.
• Speaking at a European Commission
conference in Belgium recently, he said:
"There is a big gap in the regimes for central counterparties (CCPs).”
"What happens if they go bust? I can tell you the simple answer:
mayhem. As bad as, conceivably worse than, the failure of large and
complex banks."
25

26. Counterparty Risk
Defaulting Party Impacted Party
Execution Client
Members
CCP
Clients
Default
Non-defaulting
members
A CCP Member
Clients of
defaulting
member
Clearing Client

27. Default of the CCP
• There have been examples of CCP failure - HK Futures Exchange 1987,
Caisse de Liquidation 1974, the Kuala Lumpur Commodities CCP 1983
• Main causes of a CCP failure
– Default of members that exhausts its’ “capital”
– Lack of liquidity to settle VM following a default
– Investment losses
• Ramifications
– Crystalisation of systemic risk and crash of market confidence
– All members and clients affected, positions immobilised
– Collateral may be subject to loss depending upon segregation arrangements
– Potential losses as unsecured creditors
– Inability to use cleared products if alternate CCPs unavailable
– Potential liabilities to clients if offering clearing
• Mitigating measures?
– Reduce positions
– Segregation, but its’ effectiveness is questionable
– Careful selection of CCPs balance against where liquidity resides

28. Collateral Wars

29. Collateral “wars”
• Clearing will absorb significant high grade collateral ≈ $2.5tn
• CCPs will compete on eligible collateral scope, but perversely the “loosest”
CCP will receive “rubbish” akin to ECB operation
• Higher collateral requirements on non-cleared trades than cleared trades
– US is seeking to impose initial margin for all firms within a US group
– EU moving away from initial margin requirements
• Governments will seek to influence collateral policy
• More firms will be obliged to participate/borrow in repo and stock lending
markets to meet their collateral needs
• Liquidity requirements will also mean banks have to hoard liquid assets
• Increased demands for collateral may create a squeeze on certain assets
• Firms will need to devote considerable effort to optimising their collateral
use with recognition of collateral as a tradable “asset class”
• Custodians will benefit greatly from increased demand for collateral and
new requirements to provide independent segregation

30. Cross border tensions

31. Cross Border
• The Financial Crisis highlighted the interconnectedness of the global
financial system
• Some emerging regulations appear designed either to insulate countries
from “overseas” firms; promote national firms; or retaliate against
proposals by other countries
– Use of FCMs mandated by US regulations
– DFA does not allow for the recognition of a non-US based Trade
Repository, hence it is foreseen that US registered firms will at a minimum
report to a USA Trade Repository
– S716 DFA imposes harsher conditions on US branches of non-US firms than on
US firms
• Extra-territorial provisions
– US regulations on registration as a Swap Dealer apply to non-US firms
– Collateral requirements for overseas subsidiaries of US groups
• System of international mutual recognition not established
• Regional disparities on timing and scope of new rules
• More complex corporate structures emerge to fit within regional rules

32. Timing, Scope & Policy differences
Dodd Frank EMIR
• [Wider] Scope include • Focussed upon
– Execution requirements – Clearing
– Clearing and CCPs – CCPs
– Push Out – Transaction Reporting
– Volker Rule – Trade Repositories
– Trade and transaction reporting • Implementation expected early 2013
– Trade Repositories
– Reorganisation of regulatory regime and
• Exempt pension funds and intra-group
creation of oversight council activity
– Consumer protection reforms
– Tools for financial crises, including a
"resolution regime" MIFID2 / MIFIR
– Improved accounting and tightened • Focussed upon
regulation of credit rating agencies
– Position Limits and Large Trader – Trading OTC on execution venues
reporting – Pre & post trade transparency
• Clearing implementation expected to • Implementation expected mid
start Q4 2012 with phased roll-out
2013/early 2014

33. Cross Border “SEFs”
• Based on current tensions, mutual
recognition of “foreign” platforms
looking challenging
• Likely that Execution Venues will
need approval in each jurisdiction EU approved US approved
to access users in those countries platform platform
• Hence if a firm sought to operate in
3 regions on a basis that was
accessible to clients from all
region, 9 approvals/exemptions
may be required
• Regulatory linkage between trading
Other Nations
and clearing facilities may further approved
create regional silos e.g. EU trading platforms
venue only permitted to access EU
approved CCPs [“EMIR Council
draft”]; SEFs may only clear at DCO

34. Global CCPs
• Based on current tensions, mutual
recognition of “foreign” CCPs
looking similarly challenging
• Likely that CCPs will be need
approval in each jurisdiction to EU approved US approved
access users in those countries e.g. CCP CCP
UK CCP will need to be authorised
by CFTC as a DCO
• Regulatory linkage between trading
and clearing facilities may further
create regional silos e.g. EU trading
venue only permitted to access EU
approved CCPs [“EMIR Council Other Nations
draft”] CCP
• Some countries are enacting
provisions that will demand that
their firms locally clear products in
the home currency e.g. Japan and
Canada

35. Summary

36. Summary
• Costs of using OTC products will increase, deterring use
• Most active OTC products will be mandated for clearing and trading, with
heightened transparency impacting on liquidity
• Major shift to electronic trading and adoption of trading tools from other asset
classes
• Significant increase in operational risk due to complexity of requirements
• Clearing will be a credit leveller but entails outsourcing risk management
• Counterparty risk may increase due to break-up of netting sets
• CCPs enshrined as “too big to fail” entities
• Intensive focus on collateral efficiency
• Cross border activity impeded with increased regionally focussed activity as a
consequence of regulatory barriers
• Considerable structural changes –agency business; dealer groups; new
liquidity providers;

37. Questions

38. John Wilson
John.Wilson@mpaua.com
+447850543065
http://www.linkedin.com/in/johndwilson
Twitter: @cdsclearing @irsclearing @otcclearing
@fxclearing @clientclearing @otcderivatives