Matthew Healy, vice president and general manager of Kiodex, the commodities trading unit of SunGard’s capital markets business explores how OTC derivatives regulation and the consequent changes in liquidity management are causing commodity market participants to re-evaluate where they take their financial trading volumes.
Prior to the financial crisis, companies relied heavily on the trading of OTC derivatives, rather than futures or exchange-traded options, to hedge their commodity exposures. In most cases, the two primary reasons for hedging participants to execute in the OTC space involved the liquidity provided by broker-dealers that was not available from an exchange, and more importantly, the favorable cash flow treatment from OTC collateral management. In the past few years, firms in the exchange-traded marketplace have made significant progress in improving exchange-based liquidity for many commodity markets that were not available in the recent past. While this slightly diminishes the value of trading through a dealer, the cost-benefit for hedging participants remained more than offset by the lower cash flow volatility achieved through avoiding daily margining. More recently, however, the direction of regulatory agencies and legislation in both the United States and Europe are forcing commodity market participants to re-evaluate where they take their financial trading volumes.
Regulations such as European Market Infrastructure Regulation (EMIR), the Markets in Financial Instruments Directive (MiFID) and the Dodd-Frank Act (DFA) are mandating the move of OTC derivative contracts into the realm of standardized, cleared derivatives. In light of these shifts, collateral management is moving from a reactive function to an integral component of trading and liquidity management. Counterparties will begin asking for greater transparency around banks’ methods for determining those requirements, and make trading decisions accordingly.
At the same time, clearinghouses such as the ICE and CME Group are rushing to position themselves to best capture as much new business as possible. Through replicating standard OTC derivative structures, which can vary substantially by geography and commodity, exchanges are attempting to coax participants into the ‘futurization’ process. Try as they may, it seems that the regulatory forces at work are driving the situation. For example, commodity markets in the United States are moving quickly in the ‘futurization’ direction at the behest of the CFTC, while firms in emerging markets without equal regulatory pressures happily remain in the OTC space.
