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14 July 2014

Financial News: Counter closed- The rules that will hit OTC trading


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As Europe prepares to introduce rules that will drive up the cost of over-the-counter derivatives trading, fears are growing that some investors could be left in the cold.


The regulations, likely to come into force next year, are making OTC derivatives business less profitable, leading investment banks to focus on their largest clients or walk away from the business altogether. This could leave smaller buyside clients out in the cold or force them to trade products that may not be suited to their needs. However, it also opens opportunities for non-traditional players to fill the void. Gavin Dixon, European head of derivatives clearing services at BNP Paribas, said: “There is a risk that some clients will be left in the cold as happened in the US last year. Many brokers will not necessarily have the time or resources to service all the clients that are out there. You have to prioritise and clearly, given a fixed timeline, the top priorities are going to be the clients that you already have relationships with.”

One of the measures is that these previously private deals will need to be routed via clearing houses, which will guarantee the trade even if one party collapses, reducing the risk of domino-like failures across the market. To make this guarantee possible, the clearing house holds collateral – usually cash or government bonds – which it can sell to cover the costs of any default. Clearing house members – i.e. brokers – must post collateral on behalf of their clients but also need to contribute to a default fund that is used by the clearing house in exceptional circumstances to cover any losses. The more clients a broker takes on, the larger the contribution it needs to make to the default fund. As such, brokers now have an incentive to be picky about their clients.

There is also an issue of timing. Infrequent users of derivatives or smaller firms with fewer resources may not yet have thought about the brokers they want to use, which will lead to a last-minute rush as the deadline to clear swaps approaches. Tight deadlines and a reluctance by banks and brokers to take on new business will have several consequences that might introduce new risks. If smaller clients are frozen out of the market, they could opt to trade exchange-listed derivatives rather than over-the-counter products. Infrequent users of derivatives may find adequate alternatives like swap futures – newly created listed derivatives that aim to offer a similar exposure to privately traded derivatives – but others may find these products do not meet their needs.

 

Full article (Financial News subscription required)



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