A new Greenwich Market Pulse shows that corporations and financial institutions around the world broadly agree that moving OTC derivatives trading to a system of centralized clearing would be an effective means of managing both counterparty risk at an individual level and market-wide systemic risk. However, financials and corporates also have some serious concerns about the ongoing process of market structure reform.
Some of these concerns stem from the fact that market participants are uncertain about details of the proposals being considered. Other concerns involve more informed questions among users of OTC derivatives about how the switch to centralized clearing would impact overall market liquidity and costs, as well as corporates’ ability to effectively hedge risk positions.
Mitigating Counterparty and Systemic Risks
Corporates and financial institutions around the world largely agree that the move to centralized clearing would be an effective means of mitigating issues of counterparty risk in OTC derivatives trading. Approximately 80% of survey participants overall cite counterparty risk mitigation as the primary benefit of centralized clearing, a share that approaches 90% among financials. At a broader level, almost 51% of survey participants believe a move to centralized clearing would be effective at mitigating systemic risk. “Financials and corporates agree that the need for centralized clearing is most pressing for credit default swaps, which emerged as a key source of both counterparty and systemic risk during the global financial crisis,” says Greenwich Associates consultant Woody Canaday.
Impact on Trading Volumes
As regulators, banks and customers contemplate the establishment of centralized clearing systems as a means of reducing risk, one of the critical questions they are attempting to answer is what impact that the shift would have on volumes of OTC derivatives trades. Overall, 42% of survey respondents do not think a shift to centralized clearing will have any effect on the notional trading volumes they execute in OTC derivatives. Among financial institutions, 44% of respondents agree with supporters and predict that their notional trading volumes will increase under a system of centralized clearing. “However, nearly half of the corporations surveyed indicate that they expect the notional volume of derivatives trades they execute to decrease if a centralized clearing is mandated,” says Greenwich Associates consultant Peter D’Amario. “This prediction is based on two main factors: potential increases in costs and possible decreases in customers’ ability to customize contracts.”
Impact on Costs
While half the survey respondents predict that a move to centralized clearing will lead to tighter bid/ask spreads on OTC derivatives, 47% of corporates believe the move will result in wider spreads at least in the near term. Overall, 47% of survey respondents cite the potential for increased transaction costs on OTC derivatives trades as a significant drawback of centralized clearing and 70% see the potential for increased costs associated with margin requirements as an important negative consequence. “In general, corporations participating in the study believe costs associated with creating and maintaining the centralized clearing system will ultimately be passed on to customers,” explains Greenwich Associates consultant Andrew Awad.
Impact on Customization
Approximately three-quarters of corporations fear the newly enforced standardization of contracts required by a shift to centralized clearing will limit flexibility, creating mismatches in positions and disqualifying some trades from hedge accounting. After concerns about cost increases from margin requirements, this lack of customization ranks as the most important drawback of centralized clearing in the minds of corporations. “The question of how changes in the market structure will affect companies’ ability to hedge risk exposures and positions is certainly one that should be front-and-center in discussions about a move to centralized clearing,” says Greenwich Associates consultant Tim Sangston.
Users Cite Information Shortages
Although 53% of the 330 investors and corporate executives surveyed globally by Greenwich Associates from January 11-15, 2010 describe themselves as familiar or very familiar with current proposals to establish centralized clearing for OTC derivatives, a surprisingly high 47% of respondents say they are either entirely in the dark about these initiatives or less knowledgeable than they would like to be about the details of the proposals.
Where Should Central Clearinghouses Reside?
Which organizations should run central clearinghouses for OTC derivatives? Corporates and financial institutions in continental Europe favor Eurex as the home for the region’s clearinghouse. U.K. companies and financials prefer LCH Clearnet, with Eurex and Intercontinental Exchange (ICE) also receiving votes. The preferred provider of North American corporates and financial institutions is CME Group.
D.C.