What Changes is the Buyside Adapting to in the OTC Derivatives Market?

The massive regulatory changes in the OTC derivatives market-how the products are traded, cleared and accounted for-is forcing many large buyside institutions and trading desks that utilize OTC derivatives, like interest rate swaps, to change their behavior in ways both big and small to adjust to this new trading regime and the associated costs.

Traders spoke with Steve Grob, director of group strategy for Fidessa, a U.K.-based software and trading systems service provider, and asked him what he was seeing.

Traders: Your firm works with a lot of buy- and sellside firms on trading technology and related issues. From that perspective, are you noticing traders in OTC derivatives more concerned about things like clearing costs?
Grob: Definitely-it’s clear they are looking closely at clearing and its associated costs, sometimes even more than they are looking at this or that particular swap. Now, while working with buyside clients, we’re adding the clearing conversation to the transaction, and we’re seeing that the buysider is having to develop a sort of multi-directional mindset with derivative trades. It is very interesting to see the conversation the buyside is having on clearing efficiency-simply because they didn’t have to think about this before.

Traders: That’s right, OTC derivatives were traded privately and clearing was voluntary. Now, Dodd-Frank has changed all that and clearing is going to be done through central counter-parties (CCPs) and clearing is mandatory. How is the buyside reacting to that?
Grob: They’re not just automatically trading the best price on the screen any more, but are now looking for the most beneficial trade in terms of margin and clearing cost.

Traders:One development we’ve heard about is that large buyside firms are urging the smaller banks and brokerage they deal with to offer clearing services too, in order to increase competition and lower the overall costs of clearing. Have you seen that?

Grob: Yes. Buysiders have been reaching out to smaller firms, urging them to get involved in clearing, because now that the buyside is being forced to clear, they want more choices. But to say that offering clearing services is ‘cost-prohibitive’ for some of these smaller banks, is a very polite way of phrasing it-simply, they won’t be able to make a go of it.

Traders: Also, the buyside is pressuring the clearinghouses themselves to solve some of these cost problems in terms of a more uniform system of off-setting contracts [which would allow for zeroing-out of similar, yet opposing contracts among clearinghouses and] which would allow the buyside to drastically decrease the margin it would have to put up in some of these derivative trades.
It sounds like a very different world in OTC derivatives today.

Grob:It is, and the whole thing started with Dodd-Frank-it really blew up the OTC derivative market. In the past, one large, risk-adverse buysider could simply trade derivative products with another large, risk-adverse buysider, and they could manage their risk at little cost.
But now, they have to have everything centrally cleared, the costs go up, and you have to ask whether there are going to be unintended consequences of increasing the costs of managing risk.

Traders: What would those unintended consequences be?

Grob:More overall risk. It’s like having fire insurance on your house. You have it to manage the risk of a fire, but if the monthly premiums keep going up and up and up, after a while, you might just take your chances with the risk of the fire.