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OTC derivatives prove hard to tame

OTC derivatives prove hard to tame Anthony Harrington

On the 10th September 2010 the EU tabled a proposal aimed at making the derivatives markets in Europe "safer and more transparent". This was the beginnings of EMIR, the European Markets Infrastructure Regulation. There is universal agreement that transparency and bi-lateral derivatives trading do not go hand in hand. If company A strikes an agreement to do an interest rate swap with bank B, the two parties involved know what they've done and how large the swap is, but no one else does. It is impossible for a regulator to look at a screen somewhere and see at a glance what the scale of bank B's derivatives trading is, and whether there is cause for concern there. Since the crash of 2008 woke regulators and politicians up to the fact that banks can't be trusted to manage their positions with even a smidgeon of common sense, this is a huge problem.

However, discovering that you have a problem is one thing, solving it is another. Death is a problem, if you want to keep on living, but it is not a problem to which anyone so far has found a solution. OTC derivatives might be marginally less intractable, but only marginally, it seems. The difficulty is the age old one that is generally encountered when the heavy hand of a regulatory mechanism comes down on a complex area of human activity. The temptation is always to wipe all the wrinkles away and to pretend that things have become over-complex for no good reason and all can be solved by a return to simplicity.

Michel Barnier, the EU Commissioner for Internal Market and Services put the matter succinctly when he introduced the proposed EMIR regulation:

"No financial market can afford to remain a Wild West territory. OTC derivatives have a big impact on the real economy: from mortgages to food prices. The absence of any regulatory framework for OTC derivatives contributed to the financial crisis and the tremendous consequences we are all suffering from. Today, we are proposing rules which will bring more transparency and responsibility to derivatives markets. So we know who is doing what, and who owes what to whom."

Lovely stuff, and very neatly put. However, what was always clear from the outset was that while probably around 80% of derivatives lend themselves fairly readily to standardized contracts and can be valued easily enough to be traded through the central counter parties (CCPs) mandated by EMIR, that still leaves 20% of a humongously large figure that won't fit and so will have to continue as OTC bilateral trades.

Let us pause there for a moment. The blogger, Washingtonsblog,  points out that estimates for the size of the global derivatives market range from $600 trillion to $1.5 quadrillion. So if we take the conservative figure of $600 trillion, 20% of that amounts to $160 trillion. Bear in mind that the EU is struggling to cope with bailouts of sovereign states that are orders of magnitude less than this and it should be immediately obvious that the politicians are chasing their tails, so to speak. Even if they succeed in their objective of pushing 80% of the OTC derivatives market into standardised contracts on regulated exchanges, that still leaves more than enough to pose a gigantic systemic risk.

To counter this, there are proposals to force even this rump of OTC trades to be registered. These trades may be bilateral, and too difficult for a CCP to place a value on and to take through its books, but that doesn't mean that they can't be notified to a trade repository and their terms recorded. Moreover, the proposals extend to ensuring that all swaps are fully collateralized.

I recently interviewed Ted Leveroni, head of derivatives at Omgeo, who made the point that no one really anticipated how complex it would be to bring forward workable legislation in this area. The EU's EMIR (European Markets Infrastructure Regulation) is becoming hideously complex.

"If you look at the list of challenges and issues that the regulators are dealing with as they attempt to bring forward legislation, it is clear that the list is growing exponentially," he comments.

One example is in the area of collateralization of trades. As Leveroni notes at an earlier stage in the life of EMIR, no one was talking about a collateral crunch, now it is accepted as an inevitability. If you are trying to force the adequate collateralization of all swaps, including OTC bilateral swaps, then you have to mandate more or less risk free collateral, ie cash or "guvvies" (approved government bonds). This is going to create a massive new market in upgrading collateral as organizations with "unapproved" collateral such as equities, seek to swap them for approved collateral. Entities like banks and insurance companies with large holdings of "guvvies" will enjoy profiting from this new market - not exactly what the politicians or the regulators had in mind. This in turn drives up the cost of swaps generally and that cost will inevitably be passed on to end users - again, not something the politicians or regulators intended. Under EMIR, deals that that are not cleared through a CCP and that remain bilateral trades, will still need one or other party to post an initial cash margin with a third party, and the expectation is that this margin for bilateral trades will be significantly higher than the margin that will be required for trades cleared through a CCP. So again, OTC swaps are having a very substantial layer of expense added to them.

EMIR still has some way to go but already the problems are piling up. It will be interesting to see how they are resolved in the months ahead.

Further reading on OTC derivatives:

Tags: CCPs , central clearing party , derivatives , derivatives markets , EMIR , equity derivatives , EU , interest rate derivatives , OTC , OTC derivatives , transparency
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