As we enter 2012, the OTC derivatives industry will continue to be challenged by significant regulatory requirements on both sides of the Atlantic. One of the most important was set by the G-20 at their Pittsburgh Summit in September 2009: “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”
The G-20 felt that systemic risk would be reduced if the bilateral nature of OTC derivatives contracts were to be replaced by a central counterparty through which transactions would be cleared.
We are now less than 12 months from meeting this important deadline. Yet much remains to be done.
The G-20 spoke about standardized OTC derivative contracts. Yet, the term “standardized” has yet to be adequately defined anywhere, nor have the criteria for defining a contract as standardized been established. Does the definition of a standardized product imply that it enjoys some degree of liquidity? If a product is standardized, but not liquid, can it be safely cleared? If so, under what circumstances and within what parameters?
This is not an exercise that we should underestimate. It goes to the heart of the G20 commitment. Moreover, it will help determine whether a meaningful reduction of counterparty ‒ and systemic ‒ risk occurs, or whether it will give rise to new unwanted risks that may actually increase systemic risk.
These are difficult, relevant questions. But somehow, the model that seems to be driving the regulatory process is that of the equities or futures markets. These markets, however, are different from OTC derivatives. They are open to a widely dispersed set of participants, ranging from mom and pop investors (who are managing their investments and or retirement funds), to mutual funds, hedge funds with a wide variety of strategies, arbitrageurs, high frequency traders, algorithmic strategies, asset allocators, and so on. The result is deep markets in which a large number of trades of a relatively small amount of products take place, ranging from a few shares to large block trades involving millions of shares. The order-driven auction system, which does not rely on the provision of liquidity by any single participant, but “generates” its own liquidity through the preponderance of so many players, is an appropriate fit for those markets.
The OTC derivatives markets, on the other hand, are highly institutionalized. As such, they involve a relatively limited number of participants who typically trade not as frequently and in often lumpy ways. The result is a much less liquid market. In fact, with very few exceptions (such as the US dollar and Euro denominated interest rate swap markets), most OTC derivatives markets may involve less than a few hundred trades on a daily basis. In fact, as a recent NY Fed paper indicated, many single CDS names do not trade at all on daily basis.
So, to come full circle, it remains to be seen how the definition of “standardized” product will be developed and implemented in practice. Close attention can and should be paid to not just the features of the product, but also the liquidity of the markets in which it trades. Done correctly, the focus on clearing standardized products will reduce risk. Done incorrectly, it may create unwanted risks. This will take the form of large concentrations of risk in CCPs that can not be distributed or hedged, leading to increases in systemic risk.
Food for thought for all as we go forward in 2012.