Woody Canaday, consultant,  Greenwich Associates

Investors dragging feet over central clearing rules

Investors in Europe and the United States are on notice that they will eventually be required to execute OTC derivatives trades through centrally cleared transactions. As of late 2011, however, most investors in these markets had not moved to change trading practices to accomo­date the incoming rules.

From 2010 to 2011 OTC derivatives investors executed 81% of transaction volume through bilateral OTC contracts and 19% through centrally cleared OTC contracts. Although central clearing rules are moving toward implementation, 60% of these investors have no plans to change the share of their business conducted through centrally cleared trades. In fact, while 31% of investors plan to increase the share of their business executed through centrally cleared contracts, another 9% plan to reduce that amount.
“Real money” investors make the most use of bilateral contracts, with banks, fund managers and pension funds all conducting about 95% of their OTC derivatives trading volume in commodities through bilateral contracts. Hedge funds, by contrast, execute the highest share of their OTC transaction volume through centrally cleared trades at 61%.
The results of the Greenwich Associates 2012 Commodities Investors Study show a majority of investors have no plans to change trading practices in the next year in markets in which central clearing will be required.  In the United States, 52% of investors do not plan to change the share of business done through centrally cleared trades. In Europe 71% of investors have no plans to change.
There are several reasons that investors are standing pat for now. Primarily, there is still considerable uncer­tainty about how and when new derivatives rules will be implemented in both the United States and Europe, and as such, it might not make practical or economic sense to adjust trading practices until the regulations are set in stone. Investors might be sticking with existing trading practices for as long as they can, awaiting the announce­ment of an implementation date to revise.
“Many investors simply haven’t had the information or the time to work out the precise impact of the new rules on their trading businesses,” says Greenwich Associates consultant Woody Canaday (pictured). “Most will at some point sit down to assess the impact and then move to comply. But there will be some number, including many with relatively small positions, who look at the consequences of central clearing and other rules, such as potential position limits, and decide to exit a market that may become less econom­ically attractive.”
OTC derivatives users are not optimistic about the direct effect new regulations will have on market liquidity. In both the United States and Europe, regulators are mov­ing to adopt rules promoting the use of Swap Execution Facilities (SEFs) or Organised Trading Facilities (OTFs) in OTC derivatives markets. Forty-four percent of OTC derivatives investors worldwide and more than half in Europe expect SEFs/OTFs to have a negative impact on market liquidity. Fund managers and pension funds are the most pessimistic investors, with more than 50% predicting a reduction in liquidity as a result of the move to SEFs and OTFs. Among banks and hedge funds, more than one-third of investors expect the ruling to have a negative impact on liquidity. Globally, 48% of OTC derivatives investors think the new rule will have no impact on market liquidity and 8% think it will enhance market liquidity.
The upshot of these findings: Due in large part to the lack of clarity and certainty surrounding new derivatives rules in the United States and Europe, most investors are not taking steps to prepare for a shift to centrally cleared trades. As a result, the actual implementation of man­dated central clearing could cause significant disruptions to OTC derivatives trading as investors rush to change long-established trading procedures in order to comply. While such disruptions would likely be minimal among hedge funds, many of which are already posting margins on their OTC derivatives trades, other investors will have to put aside cash to meet margin requirements and make other meaningful adjustments to their trading operations.
Based on these conclusions, Greenwich Associates recom­mends OTC derivatives investors should immediately begin assessing the economic and logistical impacts of an eventual switch to centrally cleared transactions on their own investment processes and, building on those findings, start putting in place plans for a transition to a workable new trading mix. For their part, regulators should take the industry’s lack of preparation into account when setting final implementation dates. The industry’s lack of action to this point is being driven in large part by uncertainty about the final outcome of the regulations, and rule-makers should give the industry extra time to comply.


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