Senior practitioners from across the industry provide their views on the developments and key challenges facing the OTC derivatives market.
- Paul Lewitt, Former Global Head of Credit Trading, Lloyds Banking Group
- Prof. Moorad Choudhry, Department of Mathematical Sciences, Brunel University
- Dr. Mariam Harfush-Pardo, Market & Counterparty Risk Technical Specialist, Prudential Regulation Authority
- Jean-Roch Sibille, Head of Life & Financial Risks Management, AXA Belgium
What opportunities does the current environment bring to your business?
Jean-Roch Sibille: When the Solvency II regulatory texts are finally stabilised, there could be opportunities for arbitrage between Solvency II and Basel III regulations. Banks and Insurance companies may have incentives to continue working together on some investments, for example for illiquid loans provided to mid-cap companies, for Euro Medium Term Notes (EMTN) products, for real estate structure products or for providing funds to some arbitrage desks.
What do you consider as key challenges facing the OTC derivatives market going forward?
Prof. Moorad Choudhry: I think the biggest challenge is actually a data management one. The new era of OTC derivatives is really one of collateral optimisation, and impact on balance sheet funding. Basically market participants will in effect be funding a long-dated “asset”, arising from the collateral funding requirement. This calls for real-time data processing, as participants will need to know the exact shape and content of their balance sheet, in terms of collateral requirements and collateral availability, on an intra-day basis. In essence it’s a big IT challenge. That and ensuring the availability of sufficient collateral of acceptable quality.
JRS: We are stuck between low interest rates and clients requiring guaranteed capital. It is of course difficult to satisfy these requirements. Therefore, we rely more on unit linked products for which the risks is kept by the client. For guaranteed capital products, for which the insurer takes the risks, we try to rely more and more on cash flow matching strategies to minimise interest rate risks and on the use of EMTN products.
Looking ahead, what market developments do you anticipate?
MC: It’s a tough one to call because we are entering into a potentially new way of doing things, with CCP and greater emphasis on collateral requirements to minimise Counterparty Credit Risk, and there may be consequences down the line that weren’t intended. But with exotics not expected to be included in CCP, and valuation issues made more pressing with the impact of FVA, it is tempting to think that we may head more towards a re-emphasis on vanilla derivatives. It could be that a large majority of market participants risk hedging requirements can be met with vanilla instruments.
Paul Lewitt: Currently the lack of dealer risk capital coupled with the regulatory uncertainty is creating an unstable, deeply illiquid market. Profitability will continue to fall in the markets businesses at those firms not supported by a core franchise. Marginal players will retrench and reduce their product offerings. Ultimately I expect there will be far fewer “universal banks” but stronger super regionals supported by their franchise. In response I expect buy side trading platforms, allowing firms to deal direct, will proliferate, further accelerating the fall in dealer profitability until some equilibrium is reached where dealers can earn fair returns on the risk capital they employ.
Mariam Harfush-Pardo: At the beginning of September 2013, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions (IOSCO) released the final framework for margin requirements for non-centrally cleared derivatives. Under this framework, all financial firms and systemically important non-financial entities that engage in non-centrally cleared derivatives will have to exchange initial and variation margin commensurate with the counterparty risks arising from such transactions. The framework has been designed to reduce systemic risks related to OTC derivatives markets, as well as to provide firms with appropriate incentives for central clearing. The requirement to collect and post initial margin on non-centrally cleared trades will be phased in over a four-year period, beginning in December 2015 with the largest, most active and most systemically important derivatives market participants.