The proposed enhancements to the OTC derivatives markets will not be complete until market participants fully incorporate solutions for greater price transparency and efficient trade processing.
This necessitates the use of electronic trading platforms, the "missing link" in what will ultimately represent a dramatic improvement in the world’s largest marketplace.
Not only does electronic trading provide a more efficient and effective way to execute OTC derivatives transactions, without it, full workflow automation is impossible, according to Tabb Group’s latest research report entitled, “OTC Interest Rate Swaps and Beyond: The Path to Electronic Markets.”
OTC derivatives have been characterized unfairly as common instrument types, such as interest rate swaps, had nothing to do with the financial crisis. But while OTC derivatives have been unwittingly transformed into the world’s largest punching bag, there is some justification for the brouhaha.
For many years, much-needed modernization has been put on hold and the status quo has been preserved. This is hard to justify when interest rate swaps – the largest segment of the world’s largest financial market – still have an astonishing 18 percent trade error rate. But while progress has historically been slow, there is now a lot more infrastructure and transformational development going on than meets the eye.
To date, the International Swaps and Derivatives Association (ISDA) and the Bank for International Settlements (BIS), augmented by a number of visionary market stakeholders, have provided a lot of valuable information and guidance.
In essence, the lines have already been drawn and the goals set: minimize counterparty risk and enhance market transparency.
Broad industry solutions are also generally agreed upon, although there is still some debate on the details:
- 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 establish a well-defined default management process;
- optimize financial counterbalances with improved collateral management infrastructure for the remaining subset of bilateral deals;
- amplify regulatory response tools with comprehensive, granular and timely trade repositories.
Some practical implementations of these proposals are in the field today, many of which pre-date the crush of the recent economic crisis and the ensuing glare of the spotlight, in some cases by several years. For example, at least 25 percent and as much as 30 percent of all interest rate swap exposures will be cleared through a central counterparty once the figures for year-end 2009 are in, since the adoption of CCPs is growing much faster than the market as a whole.
Other important examples, such as dealer-to-customer clearing, have been launched as this research was being assembled. All told, and given the size of OTC derivative markets, these efforts amount to an unprecedented makeover.
Upon completion of these "enhancements," the vast majority of all interest rate swaps will be centrally cleared for the benefit of all market stakeholders, and comprehensive, timely trade transparency will give regulators more of the tools they need to improve the management of unforeseen market disruptions.
Beyond the OTC derivatives market, the globally interconnected economy will be much safer than today, and the ripple effects from the default of a major financial intermediary will be significantly buffered.
Though the implementation of most of the 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, thereby finally providing the opportunity for further reduction of risks and the evolution to a more competitive and efficient marketplace.
The remaining challenge is how to inspire, convince or otherwise incentivize major dealers to move to a more automated execution solution. The sequence of maneuvers that will ultimately foster this adoption can seem unsolvable. Fortunately, this is not a metaphysical puzzle, but a question of whether it will be resolved by the markets or by mandate – and when.
About the Author
Paul Rowady is a senior analyst at Tabb Group. He has 20 years of experience in research, quantitative and fundamental investment strategies, high frequency trading, automated event-risk management systems, front-to-back office operations and hedge fund management.