The process of reforming OTC derivative markets has moved on from rule-making to implementation, allowing clients better understanding of the consequences for market structure and their economic impact.
An understanding of the economics of central clearing is vital for client decision making. Clearing houses provide benefits such as cross-party netting and counterparty credit risk absorption, but require insurance against member default in the form of margin, contributions to the default fund and bidding obligations in post-default auctions. This is passed on to clients in the form of indirect and direct costs.
On a macro level, collateral and capital requirements will be key determinants of cost evolution. Collateral demand will itself be contingent on clearing industry consolidation, extra-territorial rules and market behaviour. We estimate peak collateral demand to be in the region of USD 700bn, lower than some other estimates. Basel III capital and leverage ratio rules will drive the costs of clearing services. We anticipate that the leverage ratio could be of relatively greater importance in driving costs.
On a micro level, transaction costs will be path dependent. Our analysis suggests that central clearing will raise costs for clients who currently trade using PB in rates and FX. In FX, it may also raises costs for clients trading uncollateralized in some circumstances. For those clients that are able to choose between central clearing and bilateral trading, the trade-off between liquidity risks and higher transaction costs will be crucial.
A key theme for the market will be the fragmentation of liquidity between the cleared and non-cleared worlds. Variation margin requirements may leave real money clients an uncomfortable choice between changing asset allocations or suffering weighty capital charges. The approach of regulators to cross-border recognition of clearing regimes raises the prospects of geographical fragmentation. In any case, central clearing will necessarily only apply to the more liquid financial instruments. Counterparties holding economically equivalent bilaterally-settled and centrally cleared contracts may find them non-fungible.
Following the introduction of mandatory electronic execution requirements in the US, there has already been a substantial migration of USD denominated swap liquidity to SEF. However, there is as yet little evidence the same is true for other currencies. It remains to be seen whether liquidity will fragment between different jurisdictions, or whether SEF liquidity pools become sufficiently deep to attract voluntary participation.
One consequence of new regulations could be greater product standardization, although so far there appears to be limited take-up of products like swap futures. Ultimately standardization will depend on the trade off clients make between transaction costs and basis risks. Client-dealer relationships will also change as dealers adapt to the end of traditional business models based on warehousing risk. There are reasons to believe that barriers to entry to the dealer market may fall as balance sheet size and trading relationships become of less importance. Regulations also may influence the underlying dynamics of markets. For example, greater adoption of listed options could see gamma concentrate at discrete points.