>OTC derivatives: A new market infrastructure is taking shape

The global derivatives market has expanded enormously in recent years. Interest rate products (options and futures) have seen a particularly rapid increase over the past eight years. When volumes peaked in 2007, gross notional amounts outstanding of over-the-counter (OTC) derivatives amounted to USD 605 trillion.

A number of structural deficiencies in the market infrastructure of OTC derivatives were revealed during the financial crisis. Inherent counterparty risk and its inadequate management, the intransparency and complexity concerning actual risk exposures, and the danger of contagion, i.e. the risk of a default of one firm spreading through the financial system, are the issues that were brought to the collective consciousness in conjunction with the systemic relevance of these markets.

Traditionally, counterparty risk used to be mitigated between trading partners by means of bilateral collateralisation. While in principle collateral can be an effective insurance against counterparty credit exposure, prevalent market practices such as asynchronous collateral cycles or incomprehensive collateral coverage resulted in uncollateralised exposures in the past.

Central counterparty (CCP) clearing is the most immediate way of addressing these limitations. CCPs also reduce systemic risk, as they reduce the likelihood of contagion. Hence, regulators in the EU and the US are pushing for more OTC business to be cleared via CCPs.

Reform of market infrastructure will alter competitive structures in the industry. Rules on the eligibility of contracts for central clearing, interoperability of CCPs and ownership of the market infrastructure are issues set to shape the industry, but are undetermined at the moment.

Regulators should ensure that legislation drafted is commensurate with the risks faced. While transparency and standardisation are objectives worth of being promoted, the future of the industry will critically hinge not so much on market forces but on the outcome of the regulatory process. Regulation must strike an appropriate balance between greater stability and preserving the benefits of solid, yet dynamic derivatives markets.

To read the full report: OTC DERIVATIVES