OTC Derivatives Clearing and the Buy Side in the US: Rough Ride Ahead

by Anshuman Jaswal, PhD, October 4, 2011
Industry Trends
North America

Abstract

The overhauling of the OTC derivatives market in the form of the Dodd-Frank Act (DFA) has brought about a sea change in the clearing environment. The legislation is expected to ensure greater transparency and accountability in the system. However, the move from bilateral to counterparty clearing will require a great deal of resources on the part of market participants, especially the buy side.

In a new report, OTC Derivatives Clearing and the Buy Side in the US: Rough Ride Ahead, Celent looks at the impact of the DFA on the US OTC derivatives market. It is quite possible that the move to clearing is going to impact buy side participants more than the sell side. The new changes require an overhaul of trading platforms and connectivity. With the market volatility and the slowdown in the economy reducing their capacity to bring about improvements in their infrastructure, many of the smaller firms might struggle to meet their OTC derivatives trading requirements.

As expected, a lot of the spending will be counterparty clearing (CCP) organizations and clearing brokers establishing connectivity afresh for large-scale OTC derivatives clearing. Trading platforms and custody providers are also expected to have significant expenditure. However, the executing brokers already have most of the connectivity in place. Importantly, the buy side will also have to incur costs to establish connectivity to executing and clearing brokers, and to the CCPs. But we expect that the formation of superaggregators to combine liquidity across swap execution facilities, and initiatives by brokers to ensure overall connectivity for the buy side will help reduce costs for the latter to some extent.

“The Dodd-Frank Act is going to dramatically alter the OTC derivatives markets,” says Anshuman Jaswal, Celent Senior Analyst and author of the report. “As key participants, it is important that buy side firms are able to evolve and establish the infrastructure required to operate in the new regulatory environment.”

This report looks at the changes from the point of view of the buy side. We begin by looking at the expected trends in the OTC derivatives markets and the main changes that would be brought about by the move from a predominantly bilateral model to a CCP model. This is followed by a look at the implications for the buy side of the various changes such as the impact on collateral management, margins, reporting requirements, and so on. We also look at the possible problems or issues that could arise from the regulation. Finally, we look at the financial implications and some of the expected developments from the rise in counterparty clearing.

Celent is a research and advisory firm dedicated to helping financial institutions formulate comprehensive business and technology strategies. Celent publishes reports identifying trends and best practices in financial services technology and conducts consulting engagements for financial institutions looking to use technology to enhance existing business processes or launch new business strategies. With a team of internationally based analysts, Celent is uniquely positioned to offer strategic advice and market insights on a global basis. Celent is a member of the Oliver Wyman Group, which is a wholly-owned subsidiary of Marsh & McLennan Companies [NYSE: MMC].

Media Contacts

North America
Michele Pace
mpace@celent.com
Tel: +1 212 345 1366

Europe (London)
Chris Williams
cwilliams@celent.com
Tel: +44 (0)782 448 3336

Asia (Tokyo)
Yumi Nagaoka
ynagaoka@celent.com
Tel.: +81 3 3500 3023

Table of Contents

Executive Summary

3

Introduction

5

Market Overview

8

 

Moving from Bilateral to Central Clearing

8

 

Estimated Volumes of Cleared OTC Derivatives

8

 

OTC Derivatives Clearing and the Buy Side

9

 

Requirements of SEFs for Cleared Swaps

10

Implication for the Buy Side

11

 

Collateral Management and Margin Costs

11

 

Account Portability

11

 

Higher Margin for Noncleared Swapa

12

 

Higher Reporting Requirements

12

 

Sharing Loss in Case of Default

13

Possible Issues

14

 

Complexities of Clearing OTC Derivatives

14

 

Omnibus Vs. Segregated Accounts

14

 

Scalability

14

 

Dispute Resolution

15

 

Motivation to Clear Buy Side Trades

15

 

Regulatory Arbitrage

15

 

Other Issues

16

Process, IT, and Connectivity Aspects

18

 

Changes to Technology Infrastructure

19

Financial Implications

23

Expected Developments

27

 

Better Pricing and Greater Efficiency

27

 

CCP Consolidation

27

 

Derivatives Clearing to Enhance Value-Addition

27

 

Possibility of Regulatory Arbitrage

28

Conclusion

29

Leveraging Celent’s Expertise

31

 

Support for Financial Institutions

31

 

Support for Vendors

31

Related Celent Research

32

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