Wednesday, March 24, 2010

OTC Interest Rate Swaps and Beyond (Tabb Group)

The financial markets have been targeted in a series of industry reform debates involving the Obama administration, legislators, regulators, market stakeholders and the mainstream media. Given their global size and their potential to destabilize, if not topple, major financial intermediaries, the OTC derivatives markets have become a primary focus of the international debate.

The complex and insular world of OTC derivatives prohibits a comprehensive understanding of the relevant issues by legislators and the public at large. This lack of understanding leads to significant confusion and an ill-informed debate. But despite this confusion, the goals of reform for these markets are quite clear: to minimize counterparty credit risk and enhance market transparency. Solutions to achieve these goals – which already have broad agreement – are also clear. There are four general proposals, including:

? Enhance price discovery and straight-through processing efficiencies by migrating from bilateral and manual to multilateral and automated trading mechanisms;
? Maximize the use of central counterparties to mutualize credit risk through greater netting efficiencies and the establishment of a well-defined default management process;
? Optimize financial counterbalances with improved collateral management infrastructure for the remaining subset of bilateral deals; and
? Amplify regulatory response tools with comprehensive, granular and timely trade repositories.

Practical implementations of each of these proposals are available today, all of which pre-date the recent economic crisis and the ensuing glare of the spotlight, in some cases by as much as several years. TABB Group believes that as much as 30% of all interest rate swaps will be cleared through a central counterparty by year-end 2009, a result of growth rates in the adoption of CCPs measuring higher than market growth as a whole. Other important industry initiatives are adding to the penetration, including dealer-to-customer clearing and a greater global focus on reducing counterparty risk. All of these efforts amount to an unprecedented makeover of longstanding protocols in the OTC marketplace.

Upon completion of these industry “upgrades”, the vast majority of all interest rate swaps and a material portion of other OTC derivative asset classes will be centrally cleared. In addition, comprehensive and timely trade transparency will give regulators more of the necessary tools they need to increase effective management of market disruptions. As a result, the interconnected global financial markets will be much safer than today, and the ripple effects from the default of a major financial intermediary will be significantly buffered.

However, electronic trading platforms remain a key ingredient to future advancements and today represent the “missing link” of meaningful improvements. Although the implementation of proposed solutions has intensified, claiming victory for the combined impact of these initiatives means finding a way for the adoption of electronic trading to be dramatically increased, providing the opportunity for further reduction of risks and the evolution to a more efficient marketplace.

The major broker-dealers – those who are the counterparty to just about every trade in these markets– remain largely on the sidelines in order to maintain and protect their valuable OTC franchises. The main challenge is to inspire or convince dealers to give up their phones in favor of an automated execution solution.

The chain of events that will ultimately foster this adoption currently presents itself as an unsolvable puzzle - the financial markets’ equivalent of a “Gordian knot”. Fortunately, this is not a metaphysical puzzle, but a question of whether it will be solved by volition or mandate – and when.

The TABB Group Study on OTC Interest Rate Swaps and Beyond: The Path to Electronic Markets
This 30-page report discusses the main goals and objectives for improving the safety of the OTC interest rate swaps market – and the OTC derivatives markets, as a whole – by moving transactions away from the inherent credit and operational risks of bilateral deals, enhancing neutral and transparent price discovery, and further promoting full workflow processing efficiencies, all while preserving flexibility in deal construction. The report defines the four broad proposals to address the aforementioned goals, with “organized markets” being the proposal that involves the most disagreement, and central credit counterparties (CCPs) being the proposal with the greatest consensus. The report also outlines how adoption of electronic platforms are the missing link to completion of these market enhancements, the primary challenges to the completion of this market upgrade, and the strategies that end users can employ to overcome them.

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