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OTC Derivatives: Stakeholders Spotlight


Our first post in this series on the weaknesses within the OTC derivatives market looked at the changes that are to be brought into effect following the 2009 G-20 Summit.

The G-20 leaders agreed that to avoid a repeat of the US Sub-prime catastrophe, the trading of OTC derivatives should move away from the current bilateral arrangements between parties, towards recognised exchanges or trading platforms where appropriate.

They also agreed that all standardized OTC derivatives should be cleared through a central counterparty should be reported to trade repositories to reduce systemic risk and enhance transparency.

To achieve this, a number of stakeholders have to be brought together. In this post, we'll look at the different players within the CCP workflow and their roles.

Standardized OTC Derivatives: The Players

There are 5 key stakeholders in standardized OTC derivatives:

OTC Derivatives 1

Central Counterparty (CCP)

The CCP carries out two main processes:

  • Clearing of market transactions(identifying the obligations of the parties on either side of the transaction)
  • Settlement of market transactions(this happens when the final transaction of securities and funds occur)

This intermediary role benefits both parties to a transaction because the CCP bears most of the credit risk.

Currently, there are about a dozen CCPs clearing OTC derivatives based on interest rates, credit, equity and commodities.

The CCP can be owned by participants or monitored by the regulator and may differ on factors such as margin requirements, infrastructure or the type of products cleared.

Affirmation Platform (AP)

The Affirmation Platform provides post-trade execution for confirming and matching trade details. 

Details of the trade are input by the party executing the trade (e.g. banker or broker) and affirmed by the client. A single record of the trade details then becomes the legal confirmation of the trade and remains in the central repository.

In addition, they also enable trades to be sent to other stakeholders such as CMs, CCP and Trade Repositories as necessary.

Trade Repository (TR)

After the financial crisis highlighted the lack of transparency, regulators set up the Trade Repositories to centrally collect and maintain records of OTC derivatives' transactional data. This enhances transparency and reduces systemic risk as regulators can see a firm's underlying position and exposure from a central vantage point.

Clearing Members (CM)

Due to strict membership rules, such as an initial capital requirement, not all clients can become members of a clearing house. Therefore, CMs act as intermediary between buyers and the CCP for all post-trade functions.

Trading Venue

To comply with the new rules, all standardized instruments must be traded electronically.

In Europe, a trading venue can be a regulated market (e.g. London Stock Exchange), a multilateral trading facility (e.g. BATS/Chi-X), or an organised trading facility.

In the US, the Swap Execution Facility (SEF) provides the required platform for buyers and dealers to trade OTC cleared swaps electronically. Currently, there are no approved SEFs for OTC derivatives, but this is being reviewed.

The following diagram shows how all these stakeholders' roles fit together.

OTC Derivatives 2

Non-standardized OTC derivatives will also have to be reported to trade repositories. But they will also be subject to risk management procedures and frameworks to measure, monitor and mitigate operational risk and counterparty credit risk.

So far we have seen why these stricter measures are necessary and the parties that need to be involved to ensure they are adhered to.

In our next post we will look at how these new regulations are being adopted in the US and Europe. 

 

Posted at 08:30

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