Will the over-the-counter derivatives market disappear? The death of this market would please the popular press and some regulators, but trading financial products in a bilateral manner is in the blood of companies in all sectors, such as oil companies, consumer products companies, and, of course, financial service institutions. The failure of major OTC derivative players and public outcry ensure that the regulators will transform — though not kill — the industry. The article focuses on the most pressing issues for OTC derivatives players and analyzes the implications across business strategy, technology, IT spending and operational efficiencies.
5 Key Challenges
The top five challenges facing the industry are:
Regulation
Regulators view the OTC derivatives market as injurious to the global financial system and in need of new rules and new controls. They trusted that the industry’s view of the risks of OTC derivatives was sufficiently realistic that only a light regulatory touch was necessary. That erroneous assessment, combined with the lack of understanding of these products by legislative bodies and the general public will contribute to a hostile environment to OTC derivatives.
Evolving Market Structure
The manner in which OTC derivatives are traded and processed will evolve at an accelerated pace, resulting in a new market structure. Industry initiatives such as the "Big Bang" (a series of changes to conventions for trading credit default swaps, including auction and trading processing) and increasing product standardization (discussed below) will lead to a market structure in which products trade and are valued in a more transparent manner.
Central Clearing
Central clearing of OTC derivatives will expand broadly (to more asset classes) and deeply (to a greater percentage of transactions in an asset class) in an attempt to lessen counterparty credit risk, though it is impossible to clear all transactions. The CCP is a major component of the regulatory driver but also is unique in its influence on the industry because of the massive changes it could impart.
Product and Process Standardization
Central clearing, the Big Bang, and regulatory pressure will lead to more standard products, which in turn will lead to standardization of processes. The impact of standardization will be seen in improvement in metrics such as confirmation days outstanding.
Risk Management
Illiquidity in certain products, the need for independent and transparent pricing, and attention from stakeholders will cause users of OTC derivatives to apply more rigor to pricing, valuation, and risk management, three inextricably linked processes. Buy-side and sell-side institutions realize they need not only to bolster trader-level risk management via better pricing tools but also to look more closely at the linkages between asset classes, products, and counterparties. OTC derivatives are a form of risk assumption and risk reduction.
Implications
The byproducts of the trends described above are perhaps as important as the trends themselves. The ability to cope with the trends and succeed in the OTC derivatives market will require significant industry changes in four key areas: business practices, technology, technology spend, and operational efficiency.
Business Changes
The first decision OTC derivative business managers must make is to determine to what extent they want to continue trading these products. The risk/reward relationship has shifted, and OTC derivatives, especially the complex products, are not for everyone. If the choice is to remain in the business, then more decisions follow. First, a firm must determine with whom to trade. The analysis should cover not only the creditworthiness of the counterparty (although that is quite important) but also the suitability of the product to the client. Brokers will need to spend more time understanding their clients’ individual financial situations and deciding whether a product is appropriate for each client. The paradigm of the 2006 period was caveat emptor: The client alone was responsible for determining whether to choose the product or not. The number of local municipal entities (including school districts and hospitals) that now face massive losses due to risky derivatives will force dealers to think more about the suitability of a product for a client instead of just the profitability of the deal.
IT Enhancements
Once the business leaders determine the extent to which they wish to remain involved in OTC derivatives, they will need to adjust their technology. One of the failings of technology for OTC derivatives has been a consequence of trading firms’ habitual avoidance of big decisions such as whether to create a holistic technology infrastructure rather than modular, poorly connected applications. Unfortunately, the different stages of the transaction life cycle are not managed cohesively. TowerGroup believes a key strategy to mitigate these risks is to develop an interconnected, flexible system that allows for easier movement and analysis of transaction, position, and counterparty data. The implications for poor transaction controls span operational risk, valuations issues (how to value an instrument that is "lost" in the system), and credit and liquidity risk management.
IT Spending
IT spending on derivatives will have to be reallocated to accommodate new changes, for example in operational risk. Trading applications need to be more sophisticated and operationally broad than is possible with a spreadsheet. A front-to-back system that can track a transaction from pretrade analysis through the termination of the contract is necessary. Firms that continue to trade OTC derivatives will need to find money to fund valuations, transparency tools, and operations.
TowerGroup also expects the buy side to focus on independent valuations and the sell side to focus on risk management. A key investment will thus be data management. OTC derivatives trading firms need to bolster their data models and data governance strategies to ensure that the holdings in cross-asset-class, global trading portfolios can be quickly analyzed together. The need for real-time valuations will require vendors to embed high-performance computing into their pricing engines.
Operational Efficiency
TowerGroup believes OTC derivatives trading firms will invest in increasing automation, especially in collateral management, a process that is manual and overly dependent on e-mail for collateral calls and dispute resolution. One action item for collateral managers will be to modify their enterprise-wide exposure management processes to accommodate the combination of existing bilateral collateral management and the new multilateral netting that results from a CCP. The reduction in manual steps not just in collateral management but throughout the trade life cycle brought about by the spending on automation tools will reduce operational risk and allow risk managers to focus on the myriad other risks they face.
Together with macroeconomic conditions, the five trends described above will result in a new landscape for over-the-counter derivatives. Certain structural problems remained hidden as long as OTC derivatives were profitable and nontoxic. Now that flaws have been revealed, the industry, with a push from the regulators, will remake the OTC derivatives market to keep it alive.
This article is based on research by the Securities and Capital Markets practice at TowerGroup, a leading research and advisory services firm focused exclusively on the global financial services industry.
Contact Stephen Bruel
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