Cost of Trading and Clearing OTC Derivatives in the Wake of Margining

Recent regulations are affecting the OTC derivatives markets in complex and interrelated ways, that are changing the ways firms do business.

Over-the-counter (OTC) derivatives markets continue to be impacted by regulatory changes. These interrelated changes are affecting financial institutions and their business operations. For example, rising capital requirements are impacting profitability and return on equity market participants are now being forced to clear standard OTC derivatives trades through Central Counterparties (CCPs). Soon, there will even be margin requirements for the remaining nonstandard, uncleared derivatives (MRUDs). This is prompting firms to better assess and manage costs (funding, collateral, capital) in a consistent manner at a trade, desk and business unit level. The question is, how much of these costs can be passed on to clients?

These changes are not just impacting sell-side firms. Central clearing and MRUDs are also impacting buy-side firms on several dimensions: funding, risk management and, naturally, valuation and operations. This paper aims to better understand:

  • The various current and future regulatory initiatives – transactional and prudential.
  • The actual Margin Valuation Adjustment (MVA) and its mathematical determination through initial and variation margin adjustments, with numerical examples enriched with capital, liquidity and leverage impacts.
  • The resulting market evolution from the standpoint of pricing and volumes as well as the potential outcomes for market participants.

Following the 2008 financial crisis, the banking sector witnessed a plethora of regulatory changes. While these regulatory prescriptions cover every dimension of the banking world, the OTC derivatives (OTCDs) market has borne the brunt due to the derivatives’ opaque and complex nature. While some regulations such as the Dodd-Frank Act2, EMIR3 and the BCBS/IOSCO4 Margin Requirements of Uuncleared Derivatives are directly targeted at OTCDs, several others, especially the leverage ratio, also have far-reaching implications for the OTCD market. Figure 1 presents a timeline of major regulations impacting the OTCD market.

EMIR in the EU region and the Dodd-Frank Act for the U.S. are the major regulations covering the central clearing obligation. The implementation of mandatory central clearing for standardised OTCDs requires market participants to adhere to the CCPs’ stringent requirements including initial and variation margins (IMs and VMs). Margins, in particular IMs, which are not prevalent in bilateral deals, lead to significant funding cost for collateral. Other costs such as contributions to the default and guarantee funds of CCPs also add to the cost burden. From a broker-dealer’s self-clearing portfolio perspective, there are certain benefits accrued in terms of obviation of credit valuation adjustment (CVA) and multilateral netting.

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