Sep 25, 2014

Thinking Forward: The Business of Derivatives under New Clearing Mandates

In this video blog Udi Sela, Vice President of the Numerix Client Solutions Group and Numerix CMO Jim Jockle explore how regulatory drivers are impacting the future of the OTC derivative marketplace, and the manner in which derivatives instruments are used. Along these lines, their discussion analyzes the results of the recent Risk Magazine, Deutsches Survey of 2014: Regulatory costs drive market dynamics.

While central clearing will undoubtedly increase the cost of doing business, traditional uses of the OTC market - relied upon for its flexibility and customization also remain in check. Udi discusses the evolving market dynamics for both buy-and sell-side practitioners under new clearing mandates, examining how various market participants are adapting the way they are doing business.

Weigh in and continue the conversation on Twitter @nxanalyticsLinkedIn, or in the comments section.

Video Transcript

Jim Jockle (Host): Survey says European derivative market participants ready themselves for future clearing mandates. Welcome to Numerix video blog, I’m your host Jim Jockle. Joining me today is Udi Sela, FX Expert and Head of the Product Client Solutions Group for EMEA. Udi, Welcome.

Udi Sela (Guest): Thank you.

Jockle: So, we’re going to start with a nice quote from Ben Franklin, one of the founding fathers here in the US–it says “by failing to prepare, you are preparing to fail”. And today we’re talking about a new survey published by Deutsches Risk, that’s on, that states over one-fifth of respondents to the survey, which includes banks, asset managers, hedge funds, insurance companies, non-financial corporates, are planning for new rules to change their business operations. While almost two-thirds state that clearing will increase their cost doing derivative trades by almost five percent.

Is this in-line exactly with what you’re hearing in the market and what do you expect the trend in terms of bespoke over the counter derivative products being utilized as they are today for hedging or even the impact on standardized future products.

Sela: Well, that’s a long question. I think in general, that amongst most people there’s uncertainty and people still need to understand and are contemplating what is needed, what is required from them in terms of preparation for the regulation, so that’s one thing.

And, in general, when I look at the results of the survey, I don’t think the results are that alarming and it doesn’t seem, for now at least, that there are very, very significant changes of the landscape are to be expected. If in general, about twenty-two percent I believe, of the surveyed institutions mentioned that this regulation will impact the way they are doing derivative business.

So that’s not huge–and even of those twenty-two percent, only a portion would move to listed contracts. So for instance, you mentioned that the futurization, which we discussed on a separate video blog, I think of those twenty-two percent, thirty-four (percent) said they would use more listed products than about perhaps twenty percent would use future contracts that mimic OTC products, which are of course much more flexible.

Jockle: So, what are the results? What one could particularly argue is more operational efficiency, if more of the elements are going centrally cleared, then there’s less requirements internally for CSA management, and things of that nature. Do you foresee a welcome change as it relates to adoption of new regulatory regimes?

Sela: So I think clearly regulation is the biggest driver now. When you trade derivatives, basically people look at a few ways of how to address that. So one way of reducing capital charges, is really moving to clear trades and to trade over swap execution facilities.

Basically, the margin requirements for cleared trades are lowered, so that’s one way to benefit. But if you still want to use the OTC market, as of course it offers much more flexibility and customizing of contracts, people are now applying more and more two different methodologies to reduce risk, reduce counterparty risk, and reduce capital charges.

So one is about working on the CSA terms, and basically trying to work it in a way that you can mitigate the risk while the trade still exists. And the second thing is basically when you take the trade and you try to actually off-set them, by finding the exact matching off-setting deal (trade compression). So we see that happening too, and so these are the three ways. If you follow these paths, probably twenty percent, if you think this represents the market, and Germany is still the number four economy in the world, there might be some reduction in the OTC derivatives, but not very significant.   

Jockle: The survey itself is very wide, in terms of surveying all market participants. I think one important element is within the proposed IOSCO Rules as it relates to margin, as there are exemptions for different end users as it depends on size of threshold, and in terms of notional amounts within the portfolio.

Do you think that potentially change the skew of the survey, as it relates to how many people are going to stay with their current OTC practices, as compared to those perhaps just more sell-side institutions that do have large notional outstanding and exposures to over derivatives contracts that feel a more direct hit towards their capital reforms.  

Sela: Yes, I think this is a very reasonable approach to look at things because first of all now they are talking about exempting insurance companies from centralized clearing. I think what the regulators are trying to do is that people that use derivatives as a hedging tool, as a tool to mitigate risk on your book, will be exempt because we don’t want to increase basically the cost of operations, and by requiring more working capital, etc. And if we look at the economic cycle in Europe, for instance, where the survey was taken, the last thing decision makers want to do is to take out capital out of the market and put it as buffers.

As to banks, the activities are much more speculative. And I think this is where the regulators want to put more boundaries to make sure taxpayers money doesn’t go again to save banks. So yes, I think you will see divergence between the buy-side and the sell-side to answer your question.         

Jockle: So one of the questions that just comes to mind is as it relates to insurance companies, right now under Solvency II, a lot of European insurers are hitting different milestones as it relates to compliance which overseas has a direct impact on capital, but now with different rules as it relates to derivatives, here’s yet another capital buffer. How are insurance companies faring with two overarching regulatory regimes that impact both sides of their business?

Sela: Yes, so I think pretty much the answer is the main regulation they are subject to is really the Solvency II. And this is exactly the reason that, which of course a very heavy regulation with huge demands on capital, etc.

So I believe, or I would like to believe, that if you are like the financial regulators, which don’t come from the insurance side, pretty much rely on the Solvency II regulation that it will create sufficient buffers and there’s no need to apply additional security or safety barriers to protect the insurance companies.

And again, if you look at the economic cycle in Europe you will see the financial result of insurance companies is not something that inspires sticking up or adding additional cost in the operation.

Jockle:  Well thank you so much, Udi. And for those interested in reading the survey on Risk Magazine, Deutsches Survey of 2014: Regulatory costs drive market dynamics, it was published in the September issue authored by David Wigan.

Udi, thank you so much for joining us today and of course, we want to hear everything you want to talk about. So please follow us @nxanalytics on Twitter as well as on our LinkedIn pages or on our blogs at And we look forward to speaking with you soon. Thank you very much, Udi.

Sela: Thank you very much for having me. 

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