It is more accurate to describe impending market changes as ‘evolutionary’ rather than ‘revolutionary’, says, Sean Sprackling, partner at Investment Solutions Consultants (ISC). OTC derivatives are here to stay and will continue to be a vital financial instrument used in the financial markets, albeit in a more controlled environment.
The first half of 2009 has been a year of great uncertainty in the OTC markets as regulators around the world attempt to shore up some of the perceived risks highlighted during the turmoil of recent months. In the last few weeks, these attempts have begun to crystallise as the authorities on both sides of the Atlantic have started to reveal their hands. Today the European Commission was due to announce its plan for reforming the derivatives markets, following the pronouncements in the US last month. However that announcement has not taken place, but has rather been postponed – a sign, surely that Charlie McCreevey (the EU Commissioner) is buying time to ensure that both the US and the EU are in line with each other.
It was back in April of this year that the G20 group of industrialised and emerging countries agreed that CDS contracts should be centrally cleared, and this is expected to be a mainstay of the European regulations when they are finally announced. However in the US, the Treasury Secretary Timothy Geithner announced last month that he wanted to go further and push all “standardised” contracts onto exchanges or other trading platforms and this has, it seems, put the cat amongst the pigeons. Since then there has been a flurry of debate by interested parties on both sides, but it has lead for many to question the long-time future of the over-the-counter market given the seeming political will of the Obama administration.
So are we truly looking at the beginning of the end for the OTC Derivative? I personally think not, rather that, in the words of Churchill “…Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning…” Even determined political will is not necessarily sufficient to ensure that change is both justified and achievable, and if there is one thing that the last 18 months should have taught us, it is that we need to respond to challenges from a global perspective. Certainly in the UK there is a recognition that, whilst clearing and eventually trading of the more commoditised products is both desirable and likely, this can not ever account for the whole universe of derivative contracts. As Alexander Justham, the director of markets at the Financial Services Authority was quoted as saying the other day “…We do genuinely recognise that there is a place for this [OTC] market…”
The key word in all of this is of course “standardised”. Certain derivative contracts are naturally well suited for the move onto exchange. CDS index tranches are the most obvious example of these commoditised products, as are interest rate swaps – many of which can already be traded on the likes of Tradeweb. Moving the whole universe of these types fully onto exchange seems a natural progression as much of the infrastructure is already in place. For instance Swapclear (owned by LCH.Clearnet) in the UK has been clearing swaps for over 10 years and recently announced it would offer its services direct to the buy-side. But the fact is that there is still a vast underlying market, driven by user-demand, which by its very nature is bespoke and cannot be taken onto exchange. As the Wholesale Market Broker’s Association said the other day, “…exchange traded products do not give the same degree of cover because exchanges cannot handle that level of complexity..”
My advice to my buy-side clients is currently that they therefore ignore the challenges of trading and supporting OTC contracts at their peril. There are several reasons why the OTC market will continue to be a weapon in the armoury of investment managers, and here are just a few of them:
– The Exchanges do not want it (yet) – whilst there has obviously been an unseemly rush towards grabbing a piece of the clearing pie amongst the big global players, even they openly admit that the challenges of trading and clearing all OTC contracts are just too much to contemplate. So much so in fact that they felt the need to warn off Geithner from demanding too much go onto exchange – the COO of NYSE Liffe going so far as to say that he thought it wrong that all OTC contracts be “…put in a straight jacket on an exchange…”
– The Dealers will not let it happen – the heavyweights such as ICAP have a huge vested interest in keeping the OTC markets alive, well and paying commission. As they said in a statement last month “…The solutions to the current problems in the financial markets does not lie in attempting to mandate the transfer of OTC trading on to exchanges…”
– Hedging – amidst all the furore, it is sometimes forgotten that OTC Derivative contracts are risk management tools, and the overwhelming majority use them for this purpose. However, whether you are a corporation, a portfolio manager, or a debt manager, your precise hedging requirements will be peculiar to you and will require customised solutions if you are going to create perfect hedges. Clearly after what we all experienced in September last year, the need for sound risk management is paramount, and we should be encouraging all ways of achieving this goal.
– Financial innovation – much was made last year of the waves of Schumpeterian creative destruction caused by the financial engineers that came up with CDOs and CDO2. Indeed financial engineering has become something of a dirty word in the public psyche. Though there is some truth in this, it should not be forgotten that Schumpeter’s waves were creative rather than just destructive. The crisis may have dampened the human spirit briefly, but it will not be long before the next generation of derivative contracts emerge, and these by necessity will start of life as OTC trades and will be supported by the OTC support infrastructure that we have been building over the last few years.
– Financial products require them – over the last few years, not only are the financial contracts used in investment management getting more diverse, but so are the end-products sold to the retail, wealth, and institutional markets. There will always be a place for the talented stock-picker, but the increasingly complex demands of individual and corporate investors requires in many cases certainty of outcome. Whether you are investing because you need funds to put your kids through college, retire early and guarantee an income, or because you need to match the future liabilities of your pension obligations – you will more likely than not be best advised to use the derivative markets to create structured solutions to those outcomes. And whilst much of this hedging can come from exchange traded products, the more complex the outcome, or the more bespoke the solution will require an OTC contract.
– Concentration of risk – there has also been much debate over whether the introduction of central clearing does in fact reduce overall counterparty exposures, or whether this it is merely concentrating risk in one area. Some far more venerable authorities than I have argued for the latter and I would recommend the admirable paper by Duffie & Zhu of Stanford University called “Does a Central Clearing Counterparty Reduce Counterparty Risk?”
– Enforceability – finally and perhaps most importantly comes the question of the enforceability and practicability of implementing the changes mooted. Coming up with a meaningful definition of what a standardised contract actually means is bound, in my eyes, to failure and is more likely throw up more questions than answers. The regulators on both sides of the Atlantic have to steer a fine line between being seen to be tough and riding roughshod over the interests and advice of the actual market participants.
In conclusion, I do believe that reports of the death of the OTC derivative have been exaggerated. The market has to change, of that there is no doubt, but expect this to be an evolution rather than a revolution. The OTC derivative will continue to exist for the foreseeable future, though with a different and evolving set of contracts that are categorised in that way. We cannot therefore afford to ignore the changes coming, but similarly we cannot forsake the progress we have already made in the OTC markets to date. Change is coming to us all, but it will hopefully make for a safer, more risk managed future. And as King Whitney Jr once wrote “…Change has a considerable psychological impact on the human mind. To the fearful it is threatening because it means that things may get worse. To the hopeful it is encouraging because things may get better. To the confident it is inspiring because the challenge exists to make things better…”