the new otc derivatives landscape: (more) transparency, …. zazzara 2015 06 luxembourg_irmc_the new...
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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
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
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
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
4 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.
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
5 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.
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)
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• 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)
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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
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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
9 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.
• 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
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• 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
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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
.
12 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.
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”…
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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].
14 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.
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
15 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.
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
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APPENDICES
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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.
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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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