OTC Derivative Trade Flows Post the Dodd-Frank Act

2011

OTC Derivative
Trade Flows Post
the Dodd-Frank Act

© 2011 Headstrong Corporation. All rights reserved.

 OTC Derivative Trade Flows Post the Dodd-Frank Act
By Ben Wolkowitz and Vinod Jain , Headstrong

The extensive focus of Dodd- DFA intends for that to change.

Fr a n k A c t ( D FA ) o n O T C Regardless of the effectiveness
Standardized swaps have of the new regulations, they will
derivatives is a reflection of that
asset class’ contribution to the been migrating to exchanges necessitate substantial retooling
recent financial crisis, and the since at least 2008, and for market participants. The precise
complexity of these instruments nature of such changes will be
although the proposed dependent on the rules that are
and the associated trading and
clearing processes. Proposed reforms will likely speed being written, but the overall
reforms are comprehensive and up the transition, it is the direction and objectives of these
unless completely emasculated reforms is apparent from the Act.
swaps that are inherently not
in the rules writing process,
should dramatically change exchange or clearinghouse Currently the swaps trading
how a significant proportion of compatible that will remain a process, outlined in diagrams 1
such instruments are traded and 2, depends on whether the
source for concern. trades are conducted OTC or on
and cleared. Uppermost in these
reforms is achieving transparency an exchange. Before discussing
in what has largely been an these diagrams we want to make
opaque market, and interposing exchanges and central an important distinction relating to how a trade is cleared.
clearing between the parties to what has been an over In the most basic sense clearing refers to the counter
the counter bilateral trading arrangement. Futures parties to a trade agreeing to the terms of the trade and
markets have apparently served as a model. While confirming those terms. DFA goes a step further and specifies
appropriately aggressive and reasonable, our concern clearinghouse involvement where possible. To interpose a
is that the proposed reforms may not be entirely clearinghouse means that the trade is not only cleared in
operationally feasible particularly when the most the basic sense but also the clearinghouse guarantees the
tailored and potentially most problematic structures trade. This process is referred to as centralized clearing. This
are involved. Unique swap structures are less likely to is an important distinction that we will be referring to later
be listed by exchanges or cleared by clearinghouses on in this discussion.
© 2011 Headstrong Corporation. All rights reserved.

yet it was just such tailored structures that were at the

OTC Derivative Trade Flows Post the Dodd-Frank Act

core of the swaps related problems during the financial
crisis. A cursory examination of AIG’s swaps portfolio
at the onset of the crisis supports that point.
Swaps Processing Current and Expected
Prior to discussing our concerns, we would like to review
how swaps trades are currently processed and how the
Diagram 1 illustrates the currently most common way that
swaps are traded and cleared. The counter parties to the
trade enter into a bilateral trade agreement, the details of
which can be conveyed either manually or electronically.
When conveyed electronically the details are often routed to
a trade processing facility (e.g.MarkitSERV) where the trade
details are confirmed and the formal clearing of the trade

1
 is conducted. The more manual paper - based approach is
likely to be cleared through direct communication of the
counter parties’ operations departments. In either case the
information on the trade will be retained in a data warehouse,
administered by a clearing facility or by the counter parties
themselves depending on how the trade is cleared.
In Diagram 2 we illustrate the process when the swap
is exchange traded, a growing but still small part of the
overall trading activity in swaps. Rather than a bilateral
agreement, the counter parties convey their bids and offers
To better understand the interaction among swaps markets
participants as envisioned by the DFA consider diagram
OTC Derivative Trade Flows Post the Dodd-Frank Act
3 below. Standardized swaps will be traded on exchanges
or on Swap Execution Facilities (left undefined in DFA, but
will likely include many of the existent electronic trading
platforms in addition to new entrants to the market). Once
the trade is completed it must be cleared, which for exchange
traded swaps means that it will be centrally cleared at a
clearinghouse in the same manner that exchange traded
2
to an exchange where the trade is consummated. Trade
information is then sent to the exchange associated clearing
house where it is cleared. Once cleared the clearing house
stands between the counter parties guaranteeing both sides
of the trade. Because of that fiduciary arrangement access to
a clearinghouse is restricted to clearing members who have
satisfied particular financial requirements. Therefore a non
clearing house member wishing to trade on an exchange
must have an arrangement with a clearing house member
to represent their trades to the clearing house.
swaps are cleared currently. A clearinghouse could also
clear swaps trades executed on a Swap Execution Facility
© 2011 Headstrong Corporation. All rights reserved.
when such arrangements are established or alternatively
such swaps could be cleared in much the same way an OTC
trade is cleared. By comparison the portion of the market
represented by non-standardized swaps will be traded and
cleared in a way that is largely unchanged from current
practice. The right side of diagram 3 represents OTC trades
after the DFA, which looks much like Diagram 1 above.
 Margining Process
Key to the financial viability of a clearinghouse is the mar-
gining process whereby the counterparty to a trade, whose
initial margin falls below the maintenance level, is the recipi-
ent of a margin call. Failing to satisfy the call likely results in
involuntary liquidation of the position with losses absorbed
OTC Derivative Trade Flows Post the Dodd-Frank Act
by the residual margin left in the counterparty’s account. To
the extent that the loss exceeds the margin on deposit, the
clearing member is liable to make up the loss. If however, the
clearing member is insolvent, the clearinghouse must draw
on its own resources. This process has worked surprisingly
well throughout the history of futures exchanges. Although
the instrument itself has occasionally been the subject of
3
criticism, as a facilitator of speculation, the operation of
exchanges and their clearinghouses has generally been
above reproach.
For the exchange and clearing house arrangements to work
as well as they have requires that futures contracts satisfy
© 2011 Headstrong Corporation. All rights reserved.
several conditions. Futures contracts need to be sufficiently
liquid so that a market determined independent price is
generally available. Pricing is important for establishing
both initial and variation margin and properly administering
variation margin. Margin levels are set in direct relationship
to the recent price behavior of the instrument insuring that
risk is properly managed. Moreover, the process of margin-
 ing is dependent on a closing market price. Liquidity is also
important because it provides confidence that positions can
be liquidated without disrupting the market and at minimal,
if any, loss to the liquidator.
Clearing members form a community abiding by a given set
of rules and requirements that are enforced by the clearing-
house. Because the clearinghouse is in effect the guarantor
of all cleared trades, the identity of counterparties to a
trade is irrelevant and reversing the trade with the original
counterparties is not required. Now that most exchanges
and clearinghouses are part of public entities there are also
demands from shareholders that they perform profitably and
within the constraints of prudent risk taking.
New Role of Clearing House
Swaps began to trade over the counter because they were
tailored to the particular requirements of the counterparties,
mostly for hedging cash flows. (Prior to the financial crisis
98% of Fortune 500 companies used swaps, which outside
of the swaps dealers on the list is largely explained by hedg-
ing activities.) These characteristics facilitated hedging but
their uniqueness also ensured illiquidity where prices had
to be calculated rather than market-determined. Although
a clearinghouse’s infrastructure can be applied to clear such
an instrument, no clearinghouse would willingly guarantee
such a trade. The DFA recognizes this possibility and allows
such instruments to be traded and cleared largely as they
are now with the critical caveat that they are margined
and a capital charge, which is greater than for an exchange
traded instrument, is applied. Hedging transactions will re-
ceive advantageous treatment, which implies less stringent
capital and margining requirements than will be applicable
to the outright trading of tailored swaps. Recognizing the
economic value of swaps and not implementing barriers to
OTC Derivative Trade Flows Post the Dodd-Frank Act
such hedging activity is appropriate; however as with much
else pertaining to tailored swaps we see significant difficul-
ties in enforcement.
4
Changes in Regulatory Oversight
Regulatory oversight of OTC swaps will have to include
setting margin, determining collateral requirements and
marking positions to market. Although the dealers will be
doing the actual implementation the regulators will have to
take an intrusive role in the process to ensure compliance
and actions consistent with the objectives of the Act. This
is a complex task potentially applied to a very large number
of swaps that will require the attention of well-trained ex-
perienced supervisory staff. Moreover, if swaps applied to
hedging situations are to be treated differently there will
also need to be regulatory determination of what constitutes
a swap. The simplistic application of offsetting a cash expo-
sure with a swap appears easy enough to identify; however
not all hedges are constructed in that way. Also hedges can
quickly become speculative positions if the initial exposure
is liquidated.
Conclusion
We believe many of the proposed reforms will have a benefi-
cial effect on the swaps market, but we also believe that the
regulatory community will be tested when it comes to those
swaps that are tailored and therefore less likely to be traded
on exchanges or SEFs and cleared by clearinghouses. It will
take sensitive fine tuning to set margin requirements and
capital requirements that curtail socially undesirable risk tak-
ing while supporting legitimate hedging applications in OTC
swaps activity. Allocating sufficient and adequately trained
resources to oversee this significant portion of the swaps
market we believe will be an extremely difficult challenge
for the regulatory community to successfully undertake.
Standardized swaps have been migrating to exchanges since
at least 2008, and although the proposed reforms will likely
speed up the transition, it is the swaps that are inherently
not exchange or clearinghouse compatible that will remain
© 2011 Headstrong Corporation. All rights reserved.
a source for concern.
 2011

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About the Authors

Ben Wolkowitz is a Senior Advisor to Headstrong in New York. He advises on domain related activities
drawing on a background in fixed income markets, compliance and finance developed over a career that
included working for the Federal Reserve, teaching at the University level and hands on Wall Street ex-
perience. He has written extensively on financial markets and regulatory issues.

Vinod Jain is a Managing Consultant at Headstrong, New York. He specializes in providing business and
process consulting in OTC derivatives middle and back office processing, collateral management and
payment systems in financial industry. He tracks industry events with his research, impact articles and
contributes as a speaker to webinars and conferences.

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OTC Derivative Trade Flows Post the Dodd-Frank Act

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