CME gears up for European OTC deluge

CME Europe is hoping to capitalise on OTC reforms from London

As new rules for the central clearing of OTC derivatives loom ever larger on the horizon in both Europe and the US, technology is helping to make the transition easier – but the kind of contracts being traded are likely to change, according to CME Group.

“There is a debate in the industry about increased trading of futures instead of swaps,” said Michel Everaert, head of OTC solutions London at CME Group. “Because of the cost of collateral requirements and the risk associated with complex OTC products, some market participants are considering trading standardised futures contracts instead.”

Upcoming regulations – in particular, EMIR in Europe and Dodd-Frank in the US – mandate the central clearing and reporting of the bulk of OTC derivatives, while Basel III makes the remaining OTC products much more expensive to use by increasing the collateral requirements. The aim of the regulation is to reduce the amount of systemic risk in the banking industry, and especially in OTC derivatives markets, which were blamed by the G20 nations in 2009 as a contributor to the recent financial crisis. EMIR came into effect in December, according to the UK Financial Services Authority, but most of its provisions will be phased in over the remainder of this year and into 2014.

At present, it is estimated that the OTC derivatives market is considerably larger than the vanilla futures market – at least 10 times larger, according to some estimates. Meanwhile, the cost of options in terms of collateral is approximately five times higher, because options are considered a riskier investment. A switch to vanilla futures, traded on-exchange, could potentially enable market participants to avoid paying heavily in terms of collateral and margin when they use bilaterally traded customised contracts. However, the down side is that traders may struggle to find standardised contracts that fit their exact needs.

From a risk perspective, the idea behind requiring central clearing is that it potentially mitigates the risk of a catastrophic default, such as that which occurred to Lehman Brothers in 2008. That event contributed enormously to the credit crunch, according to Everaert, because due to complex bilateral trading and re-trading of OTC contracts, nobody knew whether the default would mean that other institutions would also go bankrupt. That in term led the banks to greatly reduce trading with each other. Under a CCP clearing model, the clearing house becomes a central repository of counterparty risk, and so in theory reduces the chances of a repeat of the Lehman’s scenario. It also monitors the trades that are coming in, effectively acting as a form of quality control.

Everaert: OTC changes netting models

“A clearing house has to look at both counterparties’ collateral and decide whether or not they have enough to accept the trade,” said Everaert. “If the clearing house does not hold enough collateral, then the trade doesn’t happen – so the clearing house is a useful tool to protect the market against excessive risk exposure.”

However, there is a catch for brokers and asset managers arising from the new rules. The anticipated switch of OTC volumes in the US and Europe to centrally cleared and traded platforms will mean that vastly more collateral will be required to maintain global derivatives markets – up to $3 trillion more, according to some estimates. That represents a significant burden for brokers, clearing members and asset managers, as well as clearing houses and central securities depositories.

Denis Peters, director of marketing and communications at Brussels-based Euroclear, recently pointed out that the situation may become even more difficult if more institutions receive credit rating downgrades, reducing the available supply of high-quality collateral.

The strain presented by the new rules has already prompted several organisations to launch new initiatives aimed at better managing scarce reserves. Earlier this month, Citi established a set of alliances with Clearstream and Euroclear Bank targeted at helping broker-dealers to cope with tougher collateral requirements. A separate alliance between central securities depositories in Germany, Spain, Brazil, South Africa and Australia has also been announced, under which the five companies will meet each quarter to work out the most efficient way of dealing with collateral.

Meanwhile, exchanges and trading venues have been keen to position themselves to take advantage of the expected windfall in exchange-trading of derivatives contracts arising from the new rules. In August 2012, the CME announced plans to bolster its European business with the launch of a London-based derivatives exchange, to be called CME Europe, with a planned start-date of mid-2013. The new exchange is expected to focus on foreign exchange futures, an asset class that the CME says is currently under-served in Europe. The company already had a clearing operation, CME Clearing Europe, which was established in May 2011.

In September, competitor the Chicago Board Options Exchange announced its own plans to set up a London hub housing CFE network equipment in a London data centre, so that European market participants can join in the 24-hour trading activity of VIX futures. Nasdaq announced its own derivatives-focused platform, Nasdaq OMX NLX, in June 2012, while Turquoise Derivatives, a new business arm of the London Stock Exchange’s MTF Turquoise, was established as far back as May 2011 partly in anticipation of a massive influx of derivatives contracts from the OTC market.

From a technological perspective, the need to handle OTC derivatives electronically is already being incorporated into exchange desktops.  CME is currently showcasing a desktop application that allows traders to see OTC trading opportunities side-by-side with standard exchange-traded futures. In theory, the electronic trading tool should make it easier for traders to incorporate OTC contracts into their electronic workflow. The technology also includes a messaging service, which can take clearing ticket information from emails, cutting the time needed to enter information into clearing manually and thereby reducing the risk of tickets being left to the end of the day or even longer.

However, recent research suggests that market participants are still struggling to deal with the new rules. On the buy-side, BNY Mellon and Rule Financial have reported that only 20% of buy-side firms have finalised their adjustments to meet the new rules. That figure concurs with separate research carried out by communications company IPC earlier this month, which found that four out of five financial institutions are not ready for new regulations governing the trading, reporting and clearing of OTC derivatives, despite the fact that 94% of respondents are already trading OTC derivatives or plan to do so in the next six months.