New directions

The financial industry sector was hard hit by the global financial crisis that unfolded in late 2008/9. The use of so called over-the-counter (OTC) derivatives also came into sharp relief thanks to a perceived lack of transparency, liquidity and the patchwork infrastructure which underpinned some of their trading activities at that time.

A common desire among politicians, regulators and financial institutions to bring more transparency and accountability to the market has since led to major moves to reform the system. A crucial G20 meeting at Pittsburgh in 2009 saw its leaders commit to ensuring all standardised derivative contracts were traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs) by an initial target date of the end of 2012. They also stated that both cleared and non cleared OTC derivative contracts should be reported to trade repositories and that non-cleared contracts should be subject to higher capital requirements.

Mixed responses

Since 2009 a variety of responses has come from the different global geographies, leading to the development of separate local or regional reforms. The Dodd-Frank Act in the US is a wide ranging reform with particular significance to the OTC derivative markets. While elements of the Dodd-Frank Act are already in force, other upcoming components of this Act will address specifics of the OTC derivatives market. European Markets Infrastructure Regulation (EMIR) in Europe also contains a number of key elements designed to reform this market. Separate but related regulatory proposals have also been proposed in Canada, Japan, China, Singapore and Australia. These countries will aim to build compatible solutions following the announcement of relevant Dodd-Frank Act and EMIR regulations.

Regulation: market timelines

Initial enforcement of specific OTC derivatives related Dodd-Frank Act rules is now planned for January 2012. In turn, the European Securities and Markets Authority (ESMA) has pledged to finalise its written rules for EMIR by December 31, 2012. It will be important for all global markets, over time, to align their various regulations in order to minimise the use of geographic arbitrage in the global market.

Yet quite how these changes will evolve across all sectors and institutions within the broader market remains unclear.

As market participants adapt there are concerns amongst some medium sized markets, such as Canada and Australia, about using non-domestic clearing solutions, with fears this could lead to a loss of control and the importation of new risk. Both of these markets are currently assessing the potential to develop new local CCP facilities. Given the complexity of the system, there are also fears among a number of market participants and regulators that the likely fragmentation of existing global arrangements could raise costs and perhaps present unforeseen complications.

Impacts and challenges

From a market size perspective, interest rate and foreign exchange derivatives represent about 80% of the total USD 600 trillion and these will be amongst the first major product segments cleared. Furthermore, some of our clients have already started using clearing houses for their OTC trades.

Market size of the OTC derivatives transactions which can be centrally cleared

Source: BIS, Deutsche Bourse, Citi Research and Analysis

OTC derivatives related elements of the Dodd-Frank Act contain specific provisions on entering into a non-cleared swap transaction.

RBC Dexia target operating model*

*Projected based on known regulation

In cases where trades are exempt from the central clearing requirements one counterparty can request an independent third-party custodian account to post collateral and margin calls (or variation margins). Under the new regulations the initial margin (or independent amount) is required to be held on a segregated account for and on behalf of the counterparty.The segregated initial margin is protected by the custodian, who secures the collateral in case the counterparty becomes insolvent. Relevant Dodd-Frank Act requirements ensure another level of collateral protection by reinvesting the initial margin in treasuries or certain government securities while the variation margin requires cash collateral.

Under the new rules, accurate OTC contract independent valuation is crucial if collateral management is to be efficient. Our clients can benefit from margin call management, securities lending services and collateral management that fully meet regulatory requirements. Offering the full integrated service for both centrally cleared and uncleared transactions, our clients will comply with the new market practices and gain a flexible end-to-end solution.

Market Responses

In terms of wider responses to the newly reformed market landscape: 

Clearing Brokers and dealers will need to appoint clearing members of one or more clearing houses in order to provide the clients with bundled clearing solutions. In turn, the various existing clearing houses all have slightly different capabilities and product offerings and may ultimately need to improve their product coverage and to partner with other market intermediaries to maximise efficiency and regulatory compliance. In this respect clearing houses are working to improve their capabilities in order to deliver optimal market segregation models for their clients. 

Asset managers will need to seek new clearing solutions if they want to retain access to the markets and OTC instruments and meet the new regulatory requirements. They will also have to demonstrate that the positions they hold in OTC derivatives are registered on central data repositories or with regulators. In order to focus on their core business and to implement the sophisticated needs it is likely that a number of hedge funds using OTC derivatives will need a full service solution, with support ranging from clearing, to reporting, to data repositories/regulators.

Investment banks decide between two models: a fully integrated clearing offering that includes execution, clearing and custody, providing operational ease and collateral safety or a bundled service offering clearing, execution and pricing. Some banks, such as Royal Bank of Canada will provide execution only, focusing on low bid/ask spreads and offering strong capabilities in any type of OTC derivative.

Other market participants, including a wide range of asset managers, hedge funds, pension funds and other investing institutions will need to develop a good understanding of all the new regulatory requirements, the changes that are mandatory and the options they face. Under the new regime, client needs will focus on a complex range of market and support services. Robust collateral management, the ability to provide transformational financing and cross-product margining are expected to be particularly important.

Custodians will also have to adopt their own response. From a custodian viewpoint the new regulations do present potential opportunities for us to help our clients, not least in handling third party OTC derivative services, which allow asset managers to focus on their core investment business. As a market participant with extensive knowledge of OTC derivatives, collateral management and reporting requirements, we can help our clients gain a better understanding of these requirements and also provide information on which clearing houses support particular offerings. Custodians can also provide services to asset managers to assist with reporting requirements for their relevant repository or regulator.

The response of various market counterparties, including CCPs, to the new regulations will ultimately define how the system will work going forward. It will take some time for institutions in this sector to develop the correct solutions and partnerships for the evolving market. The current differences in regulation adopted by different countries/regions do require careful consideration and, if necessary, expert analysis from service providers with a truly global reach and expertise in this area.

Against this backdrop of change, and despite the many important questions reform poses, RBC Dexia supports efforts to improve the transparency and risk management of the OTC derivatives markets. Ultimately we hope they will make the market even more robust and efficient and will provide a significant boost to both market liquidity and transparency.

Confidence in the OTC derivatives market was badly dented during the global financial crisis, but with OTC trading volumes now recovering, the latest upcoming regulatory reforms should provide market participants with greater comfort on risk management, liquidity and transparency in this sector once they are implemented. Our teams are already working with a number of investment banks to provide a clear, workable and straightforward solution for a fully integrated clearing service including a robust segregation account offering and a repository/regulatory reporting solution. As market change continues to evolve, RBC Dexia will endeavour to follow through on this and other supporting work to help our clients comply with the new requirements and facilitate the necessary workflow processes.

Pierre Mauchamp is Senior Manager Alternative Investments, Global Fund Products. Milena Makhmutova is Quantitative Analyst Alternative Investments, Global Fund Products. Both are based in the Paris offices of RBC Dexia.

© 2011 RBC Dexia Investor Services Limited. RBC Dexia Investor Services Limited is a holding company that provides strategic direction and management oversight to its affiliates, including RBC Dexia Investor Services Trust, which operates in the U.K. through a branch authorised and regulated by the Financial Services Authority. All are licensed users of the RBC trademark (a registered trademark of Royal Bank of Canada) and Dexia trademark, and conduct their global custody and investment administration business under the RBC Dexia Investor Services brand name.™ Trademark of RBC Dexia Investor Services Limited.

 
These materials are provided by RBC Dexia Investor Services for general information purposes only. RBC Dexia Investor Services makes no representation or warranties and accepts no responsibility or liability of any kind for their accuracy, reliability or completeness or for any action taken, or results obtained, from the use of the materials. Readers should be aware that the content of these materials should not be regarded as legal, accounting, investment, financial, or other professional advice, nor is it intended for such use. The views herein are personal to the authors and are not necessarily those of RBC Dexia Investor Services. ™  Trademark of RBC Dexia Investor Services Limited.

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