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Have the reports of the death of OTC derivatives been greatly exaggerated

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The first half of 2009 has been a year of great uncertainty in the OTC markets as regulators around the world attempt to shore up some of the perceived risks highlighted during the turmoil of recent months. In the last few weeks, these attempts have begun to crystallise as the authorities on both sides of the Atlantic have started to reveal their hands. Today the European Commission was due to announce its plan for reforming the derivatives markets, following the pronouncements in the US last month. However that announcement has not taken place, but has rather been postponed – a sign, surely that Charlie McCreevey (the EU Commissioner) is buying time to ensure that both the US and the EU are in line with each other.

It was back in April of this year that the G20 group of industrialised and emerging countries agreed that CDS contracts should be centrally cleared, and this is expected to be a mainstay of the European regulations when they are finally announced. However in the US, the Treasury Secretary Timothy Geithner announced last month that he wanted to go further and push all “standardised” contracts onto exchanges or other trading platforms and this has, it seems, put the cat amongst the pigeons. Since then there has been a flurry of debate by interested parties on both sides, but it has lead for many to question the longtime future of the over-the- counter market given the seeming political will of the Obama administration.

So are we truly looking at the beginning of the end for the OTC Derivative? I personally think not, rather that, in the words of Churchill “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning” Even determined political will is not necessarily sufficient to ensure that change is both justified and achievable, and if there is one thing that the last 18 months should have taught us, it is that we need to respond to challenges from a global perspective. Certainly in the UK there is a recognition that, whilst clearing and eventually trading of the more commoditised products is both desirable and likely, this cannot ever account for the whole universe of derivative contracts. As Alexander Justham, the director of markets at the Financial Services Authority was quoted as saying the other day “We do genuinely recognise that there is a place for this [OTC] market”

The key word in all of this is of course “standardised”. Certain derivative contracts are naturally well suited for the move onto ex- change. CDS index tranches are the most obvious example of these commoditised products, as are interest rate swaps – many of which can already be traded on the likes of Tradeweb. Moving the whole universe of these types fully onto exchange seems a natural progression as much of the infra- structure is already in place. For instance Swapclear (owned by LCH.Clearnet) in the UK has been clearing swaps for over 10 years and recently announced it would offer its services direct to the buy- side. But the fact is that there is still a vast underlying market, driven by user-demand, which by its very nature is bespoke and cannot be taken onto exchange. As the Wholesale Market Broker’s Association said the other day, “exchange traded products do not give the same degree of cover because exchanges cannot handle that level of complexity..”

My advice to our buy-side clients is currently that they therefore ignore the challenges of trading and supporting OTC contracts at their peril. There are several reasons why the OTC market will continue to be a weapon in the armoury of investment managers, and here are just a few of them:

The Exchanges do not want it (yet) – whilst there has obviously been an unseemly rush towards grabbing a piece of the clearing pie amongst the big global players, even they openly admit that the challenges of trading and clearing all OTC contracts are just too much to contemplate. So much so in fact that they felt the need to warn off Geithner from demanding too much go onto exchange – the COO of NYSE Liffe going so far as to say that he thought it wrong that all OTC contracts be “put in a straight jacket on an exchange”

The Dealers will not let it happen – the heavyweights such as ICAP have a huge vested interest in keeping the OTC markets alive, well and paying commission. As they said in a statement last month “The solutions to the current problems in the financial markets does not lie in attempting to mandate the transfer of OTC trading on to exchanges”

Hedging – amidst all the furore, it is sometimes forgotten that OTC Derivative contracts are risk management tools, and the over- whelming majority use them for this purpose. However, whether you are a corporation, a portfolio manager, or a debt manager, your precise hedging requirements will be peculiar to you and will require customised solutions if you are going to create perfect hedges. Clearly after what we all experienced in September last year, the need for sound risk management is paramount, and we should be encouraging all ways of achieving this goal.

Financial innovation – much was made last year of the waves of Schumpeterian creative destruction caused by the financial engineers that came up with CDOs and CDO2. Indeed financial engineering has become something of a dirty word in the public psyche. Though there is some truth in this, it should not be forgotten that Schumpeter’s waves were creative rather than just destructive. The crisis may have dampened the human spirit briefly, but it will not be long before the next generation of derivative contracts emerge, and these by necessity will start of life as OTC trades and will be supported by the OTC support infrastructure that we have been building over the last few years.

Financial products require them – over the last few years, not only are the financial contracts used in investment management getting more diverse, but so are the end products sold to the retail, wealth, and institutional markets. There will always be a place for the talented stock-picker, but the increasingly complex demands of individual and corporate investors requires in many cases certainty of outcome. Whether you are investing because you need funds to put your kids through college, retire early and guarantee an income, or because you need to match the future liabilities of your pension obligations – you will more likely than not be best advised to use the derivative markets to create structured solutions to those outcomes. And whilst much of this hedging can come from exchange traded products, the more complex the outcome, or the more bespoke the solution will require an OTC contract.

Concentration of risk – there has also been much debate over whether the introduction of central clearing does in fact reduce over- all counterparty exposures, or whether this it is merely concentrating risk in one area. Some far more venerable authorities than I have argued for the latter and I would recommend the admirable paper by Duffie & Zhu of Stanford University called “Does a Central Clearing Counterparty Reduce Counterparty Risk?”

Enforceability – finally and per- haps most importantly comes the question of the enforceability and practicability of implementing the changes mooted. Coming up with a meaningful definition of what a standardised contract actually means is bound, in my eyes, to failure and is more likely throw up more questions than answers. The regulators on both sides of the Atlantic have to steer a fine line between being seen to be tough and riding roughshod over the interests and advice of the actual market participants.

In conclusion, I do believe that reports of the death of the OTC derivative have been exaggerated. The market has to change, of that there is no doubt, but expect this to be an evolution rather than a revolution. The OTC derivative will continue to exist for the foreseeable future, though with a different and evolving set of contracts that are categorised in that way. We cannot therefore afford to ignore the changes coming, but similarly we cannot for- sake the progress we have al- ready made in the OTC markets to date. Change is coming to us all, but it will hopefully make for a safer, more risk managed future. And as King Whitney Jr once wrote “Change has a considerable psychological impact on the human mind. To the fearful it is threatening because it means that things may get worse. To the hopeful it is encouraging because things may get better. To the confident it is inspiring because the challenge exists to make things better..”

POSTSCRIPT: EU Press Release

The European Commission has adopted a Communication on ensuring efficient, safe and sound derivatives markets, following a commitment made in the Communication on 'Driving European recovery' ( IP/09/351 ). The Communication looks at the role played by derivatives in the financial crisis and at the benefits and risks of derivatives markets, and assesses how risks can be reduced. Following the public consultation which this Communication launches, the Commission will host a public hearing on 25 September 2009. Taking into account the outcome of the consultation, the Commission will draw operational conclusions before the end of its current man- date and present appropriate initiatives, including legislative proposals as justified, before the end of the year to increase transparency and ensure financial stability. This Communication marks another step in the Commission's efforts to strengthen the financial system in view of the failings un- earthed by the financial crisis. It responds to the commitment contained in the Communication of 4 March and is fully in line with the principles adopted by the G20 and the recommendations of the de Larosière Group. The Commission stands ready to work with authorities around the world to ensure global consistency of policy approaches and to avoid any risk of regulatory arbitrage. Internal Market and Services Commissioner Charlie McCreevy said "Derivatives markets play an important role in the economy but the crisis has shown that they may harm financial stability. As regards credit default swaps (CDS), industry has committed to clear CDS on European reference entities and indices on these entities through one or more European CCPs by 31July 2009. I expect industry to move clearing of CDS to any European CCP that has received regulatory approval for clearing indices and single names by that deadline."

Taking into account the wide diversity of 'over the counter' (OTC) derivatives markets, the Communication outlines the tools to ensure that they do not harm financial stability. These tools, which can be combined with each other, are:

Standardisation: This would enhance operational efficiency and reduce operational risks. It could be achieved by encouraging broader take up of standard contracts and electronic affirmation and confirmation services, central storage, automation of payments and collateral management processes. This requires investments and it may therefore be necessary to incentivise these investments.

Central data repositories: Such repositories collect data on, for example, number of transactions and size of outstanding positions. This increases transparency, knowledge and contributes to operational efficiency. Currently, such a repository exists for Credit Default Swaps (CDS), and could potentially be used for other derivatives segments as well. European securities regulators (CESR) are currently carrying a feasibility study for data repository based in the European Union. In the light of the forthcoming CESR report, the Commission will decide on appropriate actions.

Central Counter-party (CCP) clearing: CCPs have proven their worth during the financial crisis. In view of those benefits, the Commission has since October 2008 worked with industry to ensure that clearing of CDS takes place on

European CCPs. Industry has as a result committed to achieve CCP clearing by 31 July 2009. If industry is unable to deliver on this commitment, the Commission will have to consider other ways to incentivise the use of CCP clearing. The Commission also considers that the broader use of CCPs in other OTC derivatives markets should be incentivised, wherever possible.

Trade execution on public trading venues: For standardised derivatives that are cleared by a CCP, the question arises whether the trading of these contracts should take place on an organised trading venue where prices and other trade-related information are publicly displayed (e.g. a regulated market). This would improve price transparency and strengthen risk management. However, it could come at a cost in terms of satisfying the wide diversity of trading and risk management needs. The Commission will examine, taking into account the bespoke and flexible nature of OTC derivatives markets and the regime applicable to cash equities, how to arrive at a more transparent and efficient trading process for OTC derivatives. In this respect the Commission will further assess (i) the channelling of further trade flow through transparent and efficient trading venues and (ii) the appropriate level of transparency (price, transaction, position) for the variety of derivative markets trading venues.

The Communication also highlights the actions already undertaken in response to the financial crisis in the area of derivatives (e.g. CCP clearing for CDS, securitisation, credit rating agencies and hedge funds and other alternative investment management funds, supervision).

OTC Derivatives - Notional Amounts Outstanding Graph

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