OTC Derivatives

In April, the global banking and capital markets authorities together announced a mid-course correction to their work transforming central counterparty clearing of OTC derivatives contracts. In their search in 2009 for the answer to the ‘OTC counterparty risk problem’ that had so brutally hit the world’s financial system and economy, the authorities grasped at a notion then circulating in central banking circles: if clearing houses had proven themselves able to manage the risk of on-exchange transactions during the market turmoil of 2008 and the failure of Lehman Brothers, then they ought to be called upon to do the same for the off-exchange business that had gone off the rails.

Thomas Murray has always understood and supported the value of bespoke OTC derivatives contracts, which meet highly specific economic needs not found in the regulated marketplaces. What cannot be overlooked, however, is that OTC derivatives contributed significantly to the Global Financial Crisis of 2007-2009. One factor behind this contribution was the poor information on bilateral positions. Contracts had not been confirmed with counterparties, different terms were noted on contract notes, and on and on the information gaps went: there was no overall picture in the autumn of 2008 as to who owed what to whom, and what a given counterparty’s positions and ability to meet its commitments were, not to mention the sudden realisation that nobody knew the true value of the contacts. And so the OTC markets largely froze.

After a multitude of articles on the policy objectives of MiFID II, the new obligations of the buy- and sell-side on research and trade reporting, and the new requirements for transparency in fixed-income markets, Thomas Murray finds itself in the position of having to see how trading begins to adapt as the Directive comes into effect at the start of the year. Specialising in post-trade infrastructures and services, its business lines are not in the immediate lines of fire of this reform – its clients are, but in other of their activities.

The authorities with whom we have spoken caution that the new shape of the EU capital markets will not take form immediately, judging from how long it took to see with any certainty recurring patterns in trading after the implementation of Regulation NMS in the US and MiFID I in the EU. We have been advised to expect a period of 12-18 months in which time the order flows and ways of execution will have settled under this new regime, assuming that this adaptation is not unduly thrown off course by world events, unforeseen technological changes, and of course economic and financial changes that would alter significantly today’s outlook on trading and investment conditions. This truly is a complex mix of variability, one which does not give even the keenest of observers a clear view ahead.

The FSB (Financial Stability Board) has recently produced its ninth report on the implementation of the G20 financial reform programme as it pertains to OTC (over the counter) derivatives transactions.

There remain a number of issues that have been present almost since the beginning of the reform programme, such as cross-border regulatory issues, and a few emerging issues, not least in regards to trade reporting.

The FSB report found that:

Global regulators and financial institutions should focus on preventative rather than reactive measures to mitigate the knock-on effects of a CCP (central counterparty clearing house) running into difficulty if one of its clearing members defaults.

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