OTC Derivatives Market Reform Considerations 2. Infrastructure Supporting OTC Derivatives Markets

2.1. Introduction

Financial market infrastructures (FMIs) can greatly improve the resilience of financial markets, including many segments of OTC derivatives markets. Even where the highly bespoke nature of some contracts means that FMI usage is not appropriate, other forms of standardisation can contribute to the robustness of markets where bilateral arrangements remain important. By providing a central location for price discovery, FMIs can increase the liquidity and transparency of markets for all market participants. FMIs such as central counterparties (CCPs) also provide a benefit to the market as a whole by carrying out much of the management of the legal, operational and counterparty risks associated with derivatives trading. A particularly important aspect of a CCP arrangement is that all bilateral contracts between the various participants are replaced by a simpler set of exposures between the CCP and each individual participant, reducing the interdependence of market participants. The potential multilateral netting provided by CCPs can also result in significant liquidity and settlement efficiencies, further reducing systemic risk.

2.2. Trade Repositories

A trade repository is a centralised registry that maintains an electronic database of records of transactions. Trade information is submitted to a repository by one or both trade counterparties, and typically covers information such as transaction maturity, price, reference entity and counterparty. In the absence of trade repositories, transaction data are widely dispersed among market participants and various service providers (e.g. dealers, CCPs, trading platforms and custodians), and are often stored in incompatible proprietary systems.

For individual market participants, centralisation of trade data may assist them in understanding their own risks and exposures. Access to standardised data could allow internal and external auditors and risk management personnel to more effectively verify and track transactions and exposures. Given the use of standardised reporting formats, the use of trade repositories is also likely to encourage operational efficiencies in post-trade processing, either by the trade repository or by other service providers that use the data maintained by the trade repository. Data from a trade repository can be used to facilitate electronic trade matching and confirmation, settlement of payment obligations, trade novation and affirmation, portfolio compression and reconciliation, and collateral management.

As well as supporting risk reduction and improved operational efficiencies for individual market participants, well-designed trade repositories can also serve an important role in enhancing the transparency of information to relevant authorities, market participants and the public. This full and timely information can then be used to identify the build-up of systemic risks, help detect market abuse and, if appropriate, facilitate greater transparency in the market. Through trade repositories, aggregate market statistics might be made publicly available on a regular basis; the resulting increase in transparency may enhance market functioning, and be beneficial to confidence in times of market turmoil.

2.3. Central Counterparties

A highly effective way to manage many of the counterparty and operational risks in financial markets, while also introducing standardisation and other efficiencies into the market, is for transactions to be centrally cleared. Key to central clearing is that, through a legal process known as novation, the numerous bilateral exposures of a market participant can be substituted for a single net exposure to a CCP. The resulting multilateral netting has the potential to substantially reduce the size of individual counterparties' outstanding obligations relative to bilateral arrangements, while also reducing market-wide collateral needs. By acting as a central hub for market participants, CCPs can improve the effectiveness of default management arrangements, as well as coordinate operational improvements and efficiencies. For instance, CCPs bring standardisation of legal frameworks, streamlined day-to-day payment flows and calculations, and reduced collateral management complexities. They also provide a focal point for regulation and oversight of market-wide risk management, while also reducing information asymmetries in the market more generally.

Given these characteristics, promoting the greater use of CCPs is a cornerstone of the international reform agenda for OTC derivatives. However, in order for a CCP to clear a certain class of products safely and reliably, a number of preconditions must be satisfied:

• the product class must have a robust valuation methodology for that product so that the CCP can confidently determine margin and default fund requirements
• there must be sufficient liquidity in the market to allow for close-out and/or hedging of outstanding positions in a default scenario
• there must be sufficient transaction activity and participation so that the fixed and variable costs of clearing the transaction are covered
• there must be some standardisation of contracts, to facilitate the CCP's trade processing arrangements.

For traditional exchange-traded instruments, these tests are typically quite straightforward. In contrast, they may be more difficult for some OTC derivatives products, particularly those with highly bespoke contract terms or difficult-to-model price movements. In these situations, it is arguably not appropriate for these products to be centrally cleared. Nonetheless, there are numerous classes of OTC derivatives that are actively traded in quite standardised forms, suggesting that preconditions for central clearing potentially exist.

2.4. Exchanges and Trading Platforms

The advantages of centralised trading venues are well known. They provide a single location for buyers and sellers to meet, reducing search costs, promoting pricing competition through market transparency, and contributing to more resilient and liquid markets. Electronic trading venues can provide a host of additional operational benefits, such as verification of trade information through electronic confirmations, and facilitation of straight-through processing to CCPs and other data systems.

However, as with CCPs, there are certain preconditions for products to be successfully traded through a
centralised venue. Chief among these are that products be sufficiently standardised and liquid. There are many factors that affect market liquidity, such as:

• trading volume
• product characteristics
• transaction size
• transaction frequency
• market participant characteristics.

Where markets are liquid, buyers and sellers are able to enter and exit their positions without concern that their transactions will unduly change market prices. However, where there are fewer buyers and sellers for a product, transparency around a participant's trading intentions could move market prices in anticipation of a trade being executed. Where this reduces a participant's willingness to proceed with the transaction, this price transparency could result in reduced market liquidity. A range of OTC derivatives transactions are actively traded in standardised forms, indicating that trading venues could be viable for more of these products. Price transparency in more standardised contracts can in turn be useful in providing reference prices for less liquid contracts.

In some circumstances, a market participant may prefer to remain anonymous in undertaking a transaction. But anonymity means that the risk profile of this participant is unknown, and counterparties may be unwilling to trade where this is a significant concern. This is likely to be the case for many OTC derivatives, where counterparty exposures can be of large magnitude and of long duration. One way to facilitate anonymous trading and potentially increase market liquidity in OTC derivatives markets is for a trading venue to use a central clearing arrangement. Since a CCP applies its robust risk management requirements to clearing participants, which in turn will typically apply equivalent requirements to their clients, the market as a whole can be confident that counterparty risks are being well managed, irrespective of the identity of an individual market participant.

2.5. Other Forms of Standardisation

Notwithstanding the benefits of centralised arrangements such as CCPs and trading venues, a proportion of OTC derivatives are always likely to remain outside of these FMIs. In large part, this is because many individual end users of derivatives require tailored transaction terms. In these circumstances, other forms of standardisation of market practices could enhance overall market resilience. For instance, minimum standards of bilateral counterparty credit risk management may be one improvement. Operational improvements, such as use of trade confirmations and straight-through processing, could also improve the robustness of bilateral arrangements. An important foundation for much of this is likely to be the standardisation of data that would come from the widespread use of trade repositories.

2.6. Issues in the Increased Use of Infrastructure and Standards

Partly in response to regulatory encouragement, but also as a result of industry-driven initiatives, global OTC derivatives markets have seen some increase in the use of FMIs over the past decade or so. Central clearing arrangements for some OTC derivatives have existed for a number of years; participant uptake and the entrance of new CCPs have accelerated more recently. In certain classes of OTC derivatives, trade repositories have been developed to record transaction and counterparty details and manage trade lifecycle events, and market participants have also been increasingly using multilateral trading platforms for more standardised product classes. Progress has also been made by the industry in developing standard documentation, articulating and reporting on risk management best practices, and moving towards more streamlined and standardised operational arrangements.

However, the utilisation and development of FMIs and standards remain incomplete and slow. A key explanation for this is that the benefit to an individual market participant of using a particular arrangement depends on the number of other market participants also using it. The more other participants are already using it, the more beneficial it is to join. However, each decision-maker is unlikely to fully factor in the benefit that their participation would bring for other current and potential participants. This means that, even if there is an arrangement that would be superior for all market participants, its take-up may not occur if the network effect is a significant part of its benefit and there is no mechanism to ensure coordination across participants. An arrangement, once established, can therefore become very difficult to move away from. (The importance of network effects such as this are well understood in many other economic settings.^[1]) Where the emergence of FMIs that can serve and benefit the market as a whole depends on cooperation and investment by a large number of participants, an inability to coordinate action may mean there is little incentive for an individual participant to support this venture. While the emergence of some FMIs indicates that these ventures have been successful in receiving the support of some industry participants, their full effectiveness is unlikely to be seen unless the bulk of the market is participating.

Footnote

For instance, this has been a consideration in the Reserve Bank's recent Strategic Review of Innovation in the Payments System. Available at <https://www.rba.gov.au/publications/consultations/201106-strategic-review-innovation/issues/>. [1]