Having already examined the immediate impact of new regulations in the OTC derivatives space, in this final blog, Cristiano Zazzara analyses what the reform measures mean for the market – and the popularity of certain OTC derivatives instruments – over the longer-term.
Although several grey areas still exist around new over-the-counter (OTC) derivatives reform measures being implemented across the globe, what is clear is that these products will become more expensive to trade because of the associated margin/collateral requirements and additional capital charges. Of course, there are significant benefits to the reforms too – not least reduced counterparty risk and increased liquidity – but the significant reach of these structural measures means that firms will need to explore how to optimise their use of OTC derivatives under the new rules.
According to Euromoney, many believe, for example, that we will see a move away from the use of customised OTC swaps, in favour of standardized futures as a result of the different reporting treatment and margin requirements for swaps and futures. As firms’ tactics change, product offerings will inevitably evolve in tandem. In fact, we have already seen the appearance of futures-like products, such as CME’s ‘Deliverable Swap Futures, in response to the new regulatory environment.
These products mimic the behaviour of traditional OTC derivatives but come in the form of exchange-traded futures, offering standardised contract terms. They can be exchange-traded or cleared via Central Counterparties (CCPs) and the potential benefits of migration to these futures-like products include the reduction of counterparty risk and optimised collateral costs – according to CAIA.
Balancing the options
But obstacles to this new wave of ‘futurisation’ (the concept is not novel, but is experiencing a resurgence) also exist. At the top of the list of challenges is the limited liquidity of this market segment: CME swap futures open interest is currently around 80,000 contracts, compared to 5 million contracts for OTC interest rate derivatives.
Without a far more liquid futures-like market, firms are likely to be reluctant to transfer their OTC positions to these new products. According to CAIA, additional concerns around futurisation cited by market observers include regulatory arbitrage, as well as increased systemic risk, and a lack of customisation. It should be noted, however, that these concerns are more subjective than empirical – and that futurisation is very much in its infancy.
Change is Inevitable
Despite the hurdles, futurisation certainly has the potential to change the OTC derivatives market structure over time. But for this to happen, market participants need to become more comfortable trading OTC products, and their substitutes, on exchanges or electronic platforms.
What this means is that firms around the world must be prepared to revamp their derivatives strategies and embrace new technologies in order to successfully navigate the fast-moving market and regulatory landscape.
Read more about this in our “Understanding The New OTC Derivatives Landscape” whitepaper.