A new market is being born

One of the benefits of having big parent companies is superb access to market information. A colleague at Thomson Reuters (50% owner of Omgeo) recently distributed the following commentary about institutional investors pulling back from the OTC derivatives market:Even before a financial-regulatory overhaul takes effect, some big investors are imposing their own rules on risk. Several public and corporate pension funds are curtailing or revisiting their use of derivatives out of concern for hidden risks they may carry. In Oklahoma, a public pension fund replaced Pacific Investment Management Co., citing risks of its use of derivatives whose values could not be cross-checked in audits. Public pension funds in California and Maryland are reviewing the risks of their exposure to derivatives. State legislators in Illinois and New Jersey introduced bills to curtail the use of derivatives by their state's pension funds, citing their role in the market meltdown.For some time now Ive been scratching my head about the estimates of how much OTC business is capable of being exchange-traded and/or cleared via a CCP. A recent article in the FT by Gurtrude Tumpel-Gugerell of the European Central Bank stated that 80-90% of OTC derivatives are clearable. (Today the figure is around 10%.) This struck me as being very high indeed. Most OTC derivatives are inherently non-standard and therefore cant be exchange traded or CCP cleared but maybe the type of products traded in the future wont have the same characteristics?The OTC derivatives markets are suffering a reputation problem. Friends working in the market believe they are even less popular than estate agents, journalists and politicians! This is despite the fact that most OTC derivative transactions are originated for hedging purposes. The vast majority of the market is in Interest Rate Swaps - very dull products indeed. However policy is being driven by the attitude towards Credit Default Swaps. Its even arguable that CDOs where the real financial carnage has occurred are not derivatives at all. A CDO is a portfolio of underlying bonds. It was the bonds that went bad hence the valuation meltdown of the CDOs. Nobody refers to equity mutual funds as derivatives even though they are a portfolio of underlying equities. However perception is reality and whatever the facts its undoubtedly true that OTC derivatives are regarded as the problem.So how will 80-90% of the market become CCP eligible? Perhaps the answer lies in the behaviour of the US pension funds. These entities will always have complex investment and risk-management requirements. Their move away from OTC products is likely based on reputational risk issues rather than any real investment problem. I suspect this is a temporary phenomenon. The markets are dynamic and will surely respond to meet client needs. New products will emerge: they will be simpler, more transparent and more liquid than todays opaque OTC products. They may well be standardized enough to trade on a platform and clear through a CCP maybe up to 80-90%. The products will be respectable and widely used by public sector pension funds. The landscape will be a hybrid somewhere in-between the simplicity and transparency of todays futures market and the opaqueness and complexity of todays OTC derivatives market. Slowly but surely a new market is being born.

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