13 July 2011

Citi publishes report on OTC derivatives

The report, called 'Ready or Not – Here it Comes: OTC Derivatives in the Post-Dodd-Frank Landscape – Implications for Investment Managers', focuses on the implications of the Dodd-Frank Act for investment managers.

Investment managers trading OTC derivatives will find that the Dodd-Frank reforms have numerous and significant implications for their business. They should expect significant technology and operational challenges and may need sizeable re-engineering of their operations and technology infrastructure to prepare for central clearing, oversight and reporting, and increased reconciliations.

The increased number of connectivity points (multiple clearing members, clearinghouses, Swap Execution Facilities (SEF), Swap Data Repositories (SDR) and other market participants) will increase volume and complexity of daily reconciliations.

Market participants should expect significant impact on margin and collateral management, and should preemptively establish cross-product margining with their core bank counterparties. Overall changes in capital requirements will require enhancements to margin and collateral management functions, changing existent netting and cross-product margining, collateral optimisation and other arrangements.

Valuation needs will also change as there will be potential requirements for daily valuations of non-cleared trades, harmonisation and validation of marks.

Trade, position and risk reporting with regulators is expected to broaden and intensify.

Swap participants may have additional monitoring, compliance and reporting responsibilities, even if they are exempted from central clearing.

Citi estimates that about 60 per cent of the current OTC derivatives market by volume will be centrally cleared. This is based on the assumption that one quarter of the total volume will be “exempt” because one party to the trade is a corporate or end-user that will opt to not utilise central clearing in order to minimise working capital impact caused by Central Counterparties’ (CCP) margin requirements. Of the remaining three quarters of the OTC derivatives market “eligible” to be cleared, Citi estimates 80 per cent will be cleared through CCPs over the next few years.

Prime brokerage relationships and core bank counterparties will continue to exist. Although Citi expects a significant share of derivatives contracts to be cleared centrally going forward, there will remain derivative contracts that will not be eligible for central clearing. As such, traditional derivatives intermediation will likely continue in the near term and be complementary to CCP clearing.

Citi expects rules mandating clearing of certain vanilla Interest Rate Swaps (IRS) and Credit Default Swaps (CDS) between dealers will likely become mandatory by end of 2011. Other market participants and products will follow as CCPs gear up to clear. SEF requirements are expected to begin in 2012. Reporting requirements are likely to be fully enforced once data repositories have been established and approved by regulators.

Full report

© Citigroup