Divining the Rules of Derivatives
Divining the Rules of Derivatives
January 25, 2010
New rules governing the multi-trillion dollar over-the-counter derivatives market are expected this year, due to the central role such largely unregulated securities played in the financial crisis of 2008. The impetus for change: regulators and market participants alike cite a lack of transparency in pricing as well as inadequate risk management.
Some of the rules being proposed would require changes including: financial institutions with derivatives holdings beyond a certain threshold would be subject to new federal supervision and regulation; standardized OTC derivatives contracts would trade on electronic or voice execution platforms and clear through Centralized Counterparties (CCP); and, all OTC trades would be recorded in a central trade repository. OTC derivative dealers and major market participants that are banks will be regulated by the federal banking agencies, while those that are not banks will be regulated by the CFTC or SEC. Some-if not all-of these changes are certain to take hold in 2010.
This is expected to push derivatives trading toward markets with more standardized contracts, greater trading volume and greater price transparency. Asset and investment managers can use this clearer picture of prices on different instruments to better understand the risks that run through the broader markets, and to introduce more liquid instruments into their portfolios. For existing holdings, buy-side investment managers will need to review their current OTC derivative valuation practices - with a requirement to fully understand and assess the risks for holdings where there may be no public source of pricing information. This new world will, in any event, require that buy-side investment professionals adopt better systems to value their holdings, and to report and assess risk.
When you ask buy-side firms whether they are ready for this inevitable new environment, you often hear nervous laughter. This is because they are often reliant on what one chief risk officer of a major Wall Street buy-side firm described as a "bunch of stuff"- spreadsheets, various analytical tools and portfolio management systems rather than a sophisticated and integrated approach to operating in this changed landscape.
The challenge is not just about having the right technology. Many vendors, with years of experience in working with the sell side, have developed sophisticated products to support derivatives trading and reporting, such as Murex and Calypso. Managing a portfolio that includes complex securities, however, also requires operational and domain expertise-people, processes and governance policies. These skills are relatively abundant on the sell side, but in short supply on the buy side. Getting these capabilities in place is an essential prerequisite to trading and managing risks for OTC derivatives or structured products going forward.
Before buy-side institutions can succeed in adapting to the changing regulatory landscape, they must address the larger challenges associated with managing assets, risk and profitability. With the search for market-beating returns driving more and more buy-side firms into this asset class, here are questions they should be asking themselves:
Risk - Do you understand your credit exposure your counterparties? How has that changed over the past year? Has the exposure increased or decreased today versus yesterday? (Most buy-side firms still think in terms of monthly reports. Think daily.) What would happen if a specific counter-party went bust? Do you understand the financial status of each counterparty? Can you tell whether there has been a credit event at a counterparty and, if so, its impact on the valuation of the instruments you hold? Can you evaluate your exposure to a particular industry sector, region of the country or part of the world?
