the new otc derivatives landscape: (more) transparency, …. zazzara 2015 06 luxembourg_irmc_the new...

Cristiano Zazzara, Ph.D.Vice President, Head of EMEA Application [email protected]

International Risk Management Conference (IRMC) 2015“The New Risk Management Paradigm: How Investments, Financial Stability and Regulation will shape the European and Global Financial Markets”

Luxembourg -- June 15th, 2015

The New OTC Derivatives Landscape: (More) Transparency, Liquidity & Electronic Trading

mailto:[email protected]

Permission to reprint or distribute any content from this presentation requires the prior written approval of S&P Capital IQ.

Not for distribution to the public. Copyright © 2015 by Standard & Poor’s Financial Services LLC (S&P). All rights reserved.

Cristiano Zazzara, Ph.D.

Vice President, Head of EMEA Application Specialists

[email protected]

International Risk Management Conference (IRMC) 2015

“The New Risk Management Paradigm: How Investments, Financial Stability and Regulation

will shape the European and Global Financial Markets”

Luxembourg -- June 15th, 2015

The New OTC Derivatives Landscape:

(More) Transparency, Liquidity & Electronic Trading

mailto:[email protected]

3 Permission to reprint or distribute any content from this presentation requires the prior written approval of S&P Capital IQ. Not for distribution to the public.

Topics

• Executive Summary

• The New OTC Derivatives Landscape

• Sizing Up the OTC Derivatives Market

• Transparency: Mandatory Reporting to Trade Repositories

• Central Clearing of “Standardized” OTC Derivatives

• “Electronification”: Trading on Electronic Platforms

• Margin Requirements for Non-Centrally Cleared OTCs

• The Interplay of Basel III and the OTC Derivatives Regulation

• The “Futurization” of the OTC Derivatives Market


Executive Summary

• This note provides an overview of the OTC Derivatives Reform proposed by the G20

Leaders in September 2009 as a response to the recent subprime crisis

• The Dodd-Frank Act in the USA, the European Market Infrastructure Regulation (EMIR)

and MiFID 2 in Europe, and other legislations in Asian Countries define new rules for

this market

• Main takeaways of this note:

– The new (and evolving) OTC Derivatives regulatory landscape will definitely push

for the standardization of OTC products over time, implying a more transparent,

liquid, and simpler OTC Derivatives market

– However, bespoke OTCs will still play a significant role in the market, simply

because plain vanilla OTC instruments and Exchange-Traded Derivatives

(Futures, for example) are less suitable for hedging purposes

– The structure of the OTC Derivatives Market will change in the next years. Dealing

with this change will be an important success factor for firms around the world


The New OTC Derivatives Landscape

• Primary legislations and regulatory bodies

– U.S., Dodd-Frank: CFTC (Commodity Futures Trading Commission) and SEC (Securities

Exchange Commission)

– Europe, EMIR: ESMA (European Securities and Markets Authority) and EBA (European Banking

Authority)

– Asia, Local Legislations: Domestic regulators

• Key requirements of the reform

– Transparency: Mandatory reporting to Trade repositories (Centralized Databases)

– Central Clearing: Central Counterparties (CCPs) for standardized OTCs

– “Electronification”: Standardized OTC products to be traded on Exchanges or Electronic Platforms

– Margins and Capital requirements for Uncleared trades: Bespoke OTC products subject to

minimum Margining and higher Capital Requirements (per Basel III)


• Largest Product

Segments:

– Interest Rates

– FX

– Credit Derivatives

• Reform kicks in for new

Trades

– Back loading of old trades

not mandatory for Central

Clearing

Source: BIS, “OTC Derivatives Statistics”(April 2015). Data as of 31 December 2014.

Notional Amount Outstanding

USD Trillions Percentage

Interest Rates $505.5 80.2%

FX $ 75.9 12.0%

Credit Derivatives $ 16.4 2.6%

Equity $ 7.9 1.3%

Commodities $ 1.9 0.3%

Unallocated $ 22.6 3.6%

TOTAL $ 630.2

Sizing Up The OTC Derivatives Market

• This is a Market of $630 Trillion of Notional Outstanding

• Almost 10 times higher than that of the Exchange-Traded Derivatives ($65 Trillion)


Requirements Swap Repositories Data (SDR) Trade Repositories (TR)

Asset Class Coverage OTC OTC + Exchange-Traded Derivatives*

Mandatory Reporting Date December 31, 2012 February 12, 2014

Reporting Counterparty One Counterparty required

Both Counterparties required

(delegation of the Reporting

allowed)

Timing of the Reporting Real-Time End-of-Day

• In the past two years, Regulators finalized a series of rules related to the reporting

of Derivatives transactions in an effort to increase transparency in the market.

• This requirement went live in the U.S. (October 12, 2012) and Europe (February 12,

2014)

– Several other jurisdictions also implemented this mandate

– Although the Regulatory frameworks in the U.S. and Europe show broad similarities, there are

significant differences not only on the asset class coverage, but also on the reporting counterparty

and the time of reporting:

Source: S&P Capital IQ analysis of CFTC (2012) and EMIR (2012).

USA EUROPE

Transparency: Mandatory Reporting To Trade Repositories


Central Clearing: Mandatory OTC Clearing Roll-Out

• Mandatory clearing introduced in the U.S. for Interest Rate Swaps (IRS) and certain

Credit Default Swaps (CDS) indices, as follows:

– 11 March 2013: Swap Dealers, Major Swap Participants, and Private Client Funds

– 10 June 2013: Asset Managers

– 9 September 2013: Pension Funds

• Expected in Europe in the first half of 2016

• Implemented in Japan, Korea and India

– Rest of Asia… to be determined

• Central Clearing (via Central Counterparties, CCPs) requires for all counterparties in

a trade to post Margin (i.e., Collateral in the form of cash or securities). CCPs apply

Portfolio Risk and Pricing Models to calculate Initial and Variation Margins

• According to the Financial Stability Board (April 2014), almost 79% of Interest Rate

Derivatives (compared to 56% currently) and 51% of Credit Derivatives products

(compared to 19% currently) could be potentially centrally cleared, with obvious

implications in terms of transparency and liquidity for the entire OTC Derivatives Market


• On Oct 1st 2014, ESMA published its final draft technical standards on OTC Interest Rate

Derivatives Clearing:

– Defines types of Interest Rate Derivatives (IRD) contracts to be centrally cleared under EMIR and

implementation timeline

• Interest Rate Derivatives Classes for Clearing

– Fixed-to-Float Swaps and Basis Swaps denominated in EUR, GBP, USD, and JPY

– Forward Rate Agreements, and Overnight Index Swaps denominated in EUR, GBP, and USD

• On May 11th 2015, ESMA published another Consultation Paper proposing the addition of

the following currencies: CZK, DKK, HUF, SEK, PLN

• Timeline

Dates when IRD Central Clearing will become mandatory differ by types of counterparty

– Category 1 – Clearing Members: 6 months after the standards come into force (expected by April 2016)

– Category 2 - Financial institutions, such as Buy-Side companies, and Alternative Investment Funds: 12

months after the rules are published

– Category 3 - Other financial institutions with a low level of activity in Interest Rate Derivs: 18 months later

– Category 4 – Non-Financial Firms: 3 years from when the standards come into force.

• For Credit Derivatives, the ESMA final standards are expected in the coming months

Central Clearing: An update On The European Implementation


• In Europe, there are comparable SEFs rules for

“Organized Trading Facilities” (OTFs), as part of

the MIFID II/MIFIR legislation that has been

approved on April 15, 2014 (albeit actual

implementation will not occur till 2017)

• Although similar, there are differences between

the US and European legislations on the Asset

Class coverage:

The “Electronification” Of Standardized OTC Derivatives

• Under the new rules, OTC Standardized

Derivatives must be traded on (Multi-Dealer)

Electronic Platforms. The goal is to increase

price transparency and liquidity of OTC

Derivatives Products. In fact, up to now most of

the OTC Derivatives Trading has been

conducted by Broker Dealers on a bilateral

basis via voice execution (phone, email and

other forms of messaging), with a very

infrequent use of electronic platforms

• In the US, these rules came into effect on

February 15, 2014 for Interest Rate

Derivatives, and on February 26, 2014 for

Credit Default Swaps. Therefore, all

Standardized OTC Derivatives (that is, that are

going to be cleared) are now required to trade

on Swap Execution Facilities (SEFs) as

mandated by the CFTC

Source: S&P Capital IQ analysis on CFTC (2011), SEC (2011), and European Commission (2014) legislations.

ASSET CLASS SEF OTF

OTC DERIVATIVES

YES

(Mandatory for Cleared

products)

YES

(Mandatory for Cleared

products)

NON-EQUITY:

Bonds, Commodities,

Structured Products, etc.

NO YES

EQUITY NO

YES

(Trading on "Multilateral Trade

Facilities")

US EUROPE


New Margin Rules For Uncleared OTC Derivatives

• The last (but not least) principle on which G20 leaders agreed in 2009 was the

regulation of “Uncleared” OTC Derivatives products

- These include derivatives that are less liquid (not traded actively), less standardized and more

complex, with pricing models less readily available.

• Regulators are proposing Initial and Variation Margin for these OTC products

- This could create a potential incremental system-wide collateral demand, since the Uncleared OTC

Derivatives Market is about $230 Trillion

• On March 18, 2015, the Basel Committee and the International Organization of

Securities Commissions (IOSCO) issued their final rules on Margin Requirements for

Non-Centrally Cleared trades

- These rules will be incorporated into the Dodd-Frank (US) and EMIR (Europe) legislations, and

implemented starting from September 1st, 2016

.


The Interplay Of Basel III And The OTC Derivatives Regulation

• In addition to the Dodd-Frank Act and EMIR, another important piece of Regulation

on OTC Derivatives is the new Basel III Capital Framework

- These rules are already in force in Europe (for all Banks); in the US (for Advanced Banks) since

January 1st, 2014; and are also fully effective in Canada, India and South Korea and other

jurisdictions

• Capital Requirements are important not only for Banks subject to Basel III, but also

for all other firms: in fact, Banks are the typical counterparties of an OTC Derivative

trade

• Basel III requires additional capital requirements for Counterparty Credit Risk on

OTC Derivatives, providing a significant capital incentive to trade Centrally Cleared

versus Uncleared OTC Derivatives (for which there is an additional CVA capital

charge)

- The interaction between Basel III and the OTC Derivatives Regulation (Dodd-Frank and EMIR)

becomes apparent with regard to the treatment of Centrally-Cleared exposures. Particularly, this

happens within the “Default Waterfall” of a Clearing House (CCP) as defined by the Dodd-Frank

and EMIR Regulation. In fact, one of the CCP’s layers of defence is the Default Fund contributed

by Clearing Members as per the rules defined by Basel III

• And now, let’s enter into the Basel Regulatory Capital “Labyrinth”…


The Basel Regulatory Capital “Labyrinth”

*

**

***

Source: S&P Capital IQ analysis of Basel Committee on Banking Supervision (2006, 2011).

* Banks with an Internal VaR Model approved for General Market Risk.

** Banks with Specific Risk VaR approval for bonds and IMM approval for Counterparty Credit Risk.

*** Credit derivatives recognized to reduce risk-weighted exposure amounts for credit risk in the Banking Book do not enter the CVA Capital Charge

[European Commission: Art. 382, Capital Requirement Regulation].


The “Futurization” Of The OTC Derivatives Market

• The (evolving) regulatory landscape will definitely push for the standardization of

OTC products over time, which will imply a more transparent, liquid, and simpler

OTC Derivatives market

• However, bespoke OTCs will still play a significant role in the market, simply

because plain vanilla OTC instruments and Exchange-Traded Derivatives (mainly

Futures and Options) are less suitable for hedging purposes

- Additionally, a “Not-To-Hedge” strategy doesn’t appear to be a viable option for firms, since it will

expose them to a material volatility in their balance-sheets, with a related increase in their

probability of financial distress. No doubt firms need to increase the use of risk measurement and

management policies, and not to abandon them.

• Recently, the Derivatives market also saw the appearance of Futures-like products

- These are essentially OTC substitutes that mimic the behaviour of OTC Derivatives products but

come in the form of Exchange-Traded Futures

• Albeit still in the early days, this “Futurization” process will likely change the OTC

Derivatives market structure over time

- But only when market participants will become more comfortable trading OTC products (and

substitutes) on Exchanges or Electronic Platforms


Further Reading

• Bank for International Settlements, “OTC Derivatives Statistics at end-December 2014”, April 2015

• Basel Committee on Banking Supervision, “Basel III: A Global Regulatory Framework for more

resilient Banks and Banking Systems”, June 2011.

• Basel Committee on Banking Supervision and IOSCO, “Margin Requirements for Non-Centrally

Cleared Derivatives”, March 2015

• Commodity Futures Trading Commission, “Clearing Requirement Determination under Section

2(h) of the CEA”, 2012

• Dodd-Frank Wall Street Reform and Consumer Protection Act, June 2010

• European Securities and Markets Authority (ESMA), “Draft technical standards on the Clearing

Obligation – Interest Rate OTC Derivatives”, October 2014

• European Securities and Markets Authority (ESMA), “Clearing Obligation under EMIR (no. 4)”,

May 2015

• European Commission, “European Market Structure Infrastructure Regulation (EMIR)”, July 2012

• European Commission, “Markets in Financial Instruments (MiFID II)”, April 2014

• Financial Stability Board, “OTC Derivatives Market Reforms”, Eighth Progress Report on

Implementation, November 2014

15


APPENDICES


Overview And Timeline Of OTC Derivatives Regulation

REGULATION MAIN REQUIREMENT DESCRIPTION TIMELINE

DODD-FRANK

- Central Clearing - Mandatory clearing of certain classes of OTC derivatives From Q1 2013

- Reporting- Mandatory Reporting of certain information to Swap Data Repositories. Real-time

dissemination of certain aggregated data. Regulatory access to detailed information From Q4 2012

- Execution and Transparency- Mandatory execution of certain derivatives through approved execution facilities

(SEFs). Pre and post trade transparency requirementsFrom Q1 2014

- Registration of OTC entities - Registration of entities meeting the Swap Dealer or Major Swap Participant definitions From Q4 2012

EMIR

- Central Clearing - Mandatory clearing of certain classes of OTC derivatives

Rules not yet finalized.

Implementation

expected in H1 2016

- Reporting- Mandatory Reporting of certain information to Trade Repositories. Public dissemination

of certain aggregated data. Regulatory access to detailed information From Q1 2014

- Risk Mitigation for Uncleared

trades

- OTC Derivative contracts which are not subject to Clearing will be subject to risk

mitigation, such as requirements for timely confirmation and reconciliationFrom Q1 2013

- Capital adequacy for CCPs - Enhanced Capital requirements for Central Counterparties From Q1 2013

MIFID 2 - Execution and Transparency

- Establishes a range of trading venues and requirements for pre/post trade

transparency. Mandatory execution of OTC derivatives and of other non-equity asset

classes through approved execution facilities (OTFs)

Rules not yet finalized.

Implementation

expected end-2016

BASEL III

- Enhanced RWAs for market

risk and securitisation

- Increase in Risk Weighted Assets due to adoption of VaR and Stressed VaR for OTC

Derivatives in the Trading Book

- Europe: from end-2011

- US: From Q1 2013

- New RWAs for Centrally

Cleared trades

- Risk Weight between 2% and 4% for Centrally-Cleared Trades

- Capital charge on Default Fund exposure for Clearing Member Banks

- Europe: From Q1 2014

- US: From Q1 2014 (only

for Advanced Banks)

- Enhanced Counterparty credit

risk RWAs for Uncleared

trades

- Implementation of Counterparty Valuation Adjustment (CVA) regime

- Europe: From Q1 2014

- US: From Q1 2014 (only

for Advanced Banks)

BCBS-IOSCO- Margin requirements for

Uncleared OTC Derivatives- Mandatory two-way Initial Margin for covered entities From Q3 2016

Source: S&P Capital IQ.


Glossary: Some Key Terms Defined

Acronym In Full

BCBS Basel Committee on Banking Supervision

BIS Bank for International Settlements

CCP Central Counterparty (i.e. Clearing House)

CDS Credit Default Swap

CFTC Commodity Futures Trading Commission

CPSS Committee on Payment and Settlement Systems

CRD Capital Requirements Directive

CRR Capital Requirements Regulation

CSA Credit Support Annex

CVA Credit Value Adjustment

EBA European Banking Authority

EMIR European Markets Infrastructure Regulation

ESMA European Securities and Markets Authority

ETD Exchange- Traded Derivative

EWMA Exponentially Weighted Moving Average

IM Initial Margin

IOSCO International Organisation of Securities Commissions

Acronym In Full

IRS Interest Rate Swap

ISDA Interest Rate Swap and Derivatives Association

LEI Legal Entity Identifier

MIFID Markets in Financial Instruments Directive

MIFIR Markets in Financial Instruments Regulation

OTC Over The Counter

OTF Organised Trading Facilities

RWA Risk Weighted Asset

SDR Swap Data Repositories

SEC Securities and Exchange Commission

SEF Swap Execution Facility

TR Trade Repositories

VaR Value-at-Risk

VM Variation Margin

Source: S&P Capital IQ.


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