OTC Derivatives, Systemic Risk and Market Structure

Author Name: 
Romain Devai, Research and Projects Manager, WFE

With the passage of legislation in the United States to transform Over-the-Counter (OTC) derivatives market, and similar measures in the works in Europe, the leaders of exchange industry sought the most up-to-date information on one of largest and most opaque parts of modern finance. 

Reform of these non-regulated markets and products has been a priority for the G20 governments and regulators. They have been seen as a central cause and accelerator of the crisis that brought down financial institutions.  

The solution to reduce systemic risk is recognized in the exchange traded and centrally-cleared markets for derivatives. In order to understand how feasible this process could be, an in-depth review of most asset classes and products was needed using data from the Bank for International Settlements (BIS), the International Swaps and Derivatives Association (ISDA) and the World Federation of Exchanges (WFE). 

The result of this review is The Global Risk Transfer Market: Developments in OTC and Exchange-Traded Derivatives, by the Tabb Group which has the great merit of providing a clear picture of derivatives markets, some of their weaknesses and ways to improve their overall security. 

The title of the study recalls why the derivatives instruments have become so important as they perform a key economic and financial feature: risk transfer enables hedging but also investing and trading. It also highlights the fact that derivatives have reached a prominent position in financial markets, and have spread all over to reach a global dimension. 

Eventually, the title also emphasizes the different natures between OTC derivatives (OTCD) and exchange-traded derivatives (ETD) as well as their possible convergence towards a similar model. This dynamic does not mean an unrealistic transfer of the all OTC instruments to the ETD environment but rather a convergence of the OTCD model towards the ETD one as “given its standards, fault tolerance and capacity, the ETD market is currently the best model we have for operational integrity.”[1] 

Here is a short review of the main findings of this study.

OTC Derivatives, systemic risk and market structure

The mere size of the OTCD market (around an astonishing $ 600 trillion of notional value outstanding for the last four years), its global dimension, and its lack of adequate collateral have, as a result, created significant systemic risk to the overall financial system. 

One of the main finding from the study is that:

Despite strong growth in the use of collateral agreements and proportion of collateralized transactions, TABB Group estimates that the total collateral commitment in OTCDs today is too low.

The study goes further and estimates that:

The additional collateral required in OTCD markets could be about $2 trillion, globally.

This figure is not trivial by any standards, and it will take time and important market structure modifications to allocate the necessary collateral. Nevertheless a progressive transition is the most likely, starting with the most standardized and liquid products.

TABB Group estimates that the near term collateral impact of moving additional standardized OTCD interest rate and credit exposures to CCPs is approximately $240 billion.

It is very important to underline that this missing collateral is an actual very tangible risk to the financial system, and should therefore not been seen as an unnecessary additional burden that will need to be borne by market participants and/or end-users ultimately. 

Also, it is very important to stress that:

The cost of collateral is a capital efficiency issue; it should be categorized as an opportunity cost, not a sunk cost.

In addition to this major risk, the current OTC derivatives structure is not efficient. It is largely based on a “bilateral paradigm” where:

The primary implicit cost is the bid-ask spread (BAS) which currently dominates the pricing structure since price transparency and access are low. As long as a small group of dealers control OTCD markets, the BAS will remain wide.

In order to address these two issues, the study proposes common sense solutions: 

  • In order to minimize systemic and counterparty risks: “central counterparty clearing (CCP) for standardized instruments, and margin requirements for all transactions (both standardized and exotic, cleared and bilateral).”
  • And in order to improve price transparency: “increase multilateral price discovery through exchange-like mechanisms, or swap execution facilities (SEFs).”

Expected benefits of moving to the ETD paradigm

Whereas standardization is deemed as a key prerequisite for implementing the objectives of clearing and transparency, the study estimates that:

Over 90% of OTCD exposures are sufficiently standardized to be applicable to both SEFs and CCPs.

The study includes a survey of key market participants showing that:

Nearly all market players believe that bid-ask spreads will tighten and per-trade commissions will shrink following OTCD reform.

This sentiment is backed by Tabb Group :

While not all OTCD products will enjoy the full extent of ETD costs efficiencies over the longer term –particularly due to the ongoing utility of certain exotic trade structures –the OTCD market will enjoy material cost decreases (on an average trade cost basis) principally due to the high proportion of standard products like Interest Rate swaps, Foreign Exchange swaps, and Credit Default swaps.

Comparing OTCD and ETD cost structures is not straightforward as the OTCD market is mostly a “bilateral paradigm” with important implicit cost (bid-ask spread) whereas the ETD market is more straightforward to apprehend through its more explicit costs. 

The study proposes such a comparison on several products and also highlight that another expected benefit from the ETD structure is to increase trading volume which would be a key driver for cost reduction.

Greater volume will yield lower trading costs; High notional and high turnover OTCD products (like IR swaps, FX swaps, and CDS indices) have the greatest potential to approach ETD pricing, or up to 89% savings, at the limit.

In order to reach this benefit, the market structure has to become more open and transparent as Tabb Group notes that liquidity “is dependent, in large part, on access”. 

As the section on transaction cost analysis concludes: 

The ETD side of the Global Risk Transfer Market provides a clear roadmap for how to best accomplish the goals of systemic and counterparty risk mitigation.

 Source: TABB Group Study

As emphasized above, clearing is an essential part for building a safer market, and this could be achieved on a large scale.

TABB Group estimates that as much as 90% of total OTC interest rates derivatives –all but the most exotic –will ultimately be centrally cleared.

It is nonetheless important to avoid a one size fits all approach, impose mandatory clearing on all products, and keep clearinghouses responsible to choose what they clear.

Clearinghouses must have control over what they clear to ensure that new systemic risk is not created. If products cannot be valued, then margin (a key risk management tool) cannot be accurately calculated, and therefore, the product cannot be cleared.

Another important aspect of clearing is that it provides a more level playing field between market participants, thus favoring a more open and transparent market structure.

An anonymous clearing environment allows for anonymous trading, opening up the space to all that have the capital to support OTCD strategies, whereas in the previous, bilateral world dealers could (and did) decide to trade only among themselves.

Conclusion for exchanges

The study provides an extraordinary rich content. It provides useful insights about market sizing, market participants, regulatory evolutions, products specificities. This short summary is really meant to be a short introduction to reading the full Tabb study which contains very detailed data, facts and analysis. 

The study then goes well beyond the particular prism of exchanges, but since this summary was prepared for Focus, we wanted to highlight a few conclusions for exchanges. 

A first conclusion relates to the geographic balance in derivatives and the potential growth of the Asia Pacific (APAC) region (a trend already well established in cash equities). The study emphasized the North Atlantic weight in the OTCD...

Europe remains the epicenter of OTCD dealing due to London’s dominance in dealing interest rate dealing. However, it is slowly ceding its dominance as US and APAC activity grows.

... And the potential for the Asia Pacific region:

With at least 32% of global GDP in 2009, TABB Group expects APAC derivative markets to grow significantly in the future. The main argument against this expectation is whether risk transfer in APAC-centric interest rate derivatives is being conducted in other regions, thereby decoupling risk transfer from geography. Though likely, it should be combated by APAC dealers and exchanges.

Overall, the OTCD will likely converge to the ETD paradigm, but this convergence will not be a mere transfer of activity from one to the other. Exchanges have to remain highly innovative to offer specific solutions for OTCD.

Exchanges have opportunity in nearly every aspect of the OTC derivative market, however, they must not assume that these products will fit nicely into their existing models and instead create new paradigms suited to OTC derivative trading.

The work to reduce systemic risk, and thus avoid another financial meltdown, is now underway. Exchanges are prepared not only to analyze the past, but shape the future.

As the new WFE Chairman Ronald Arculli, the Chairman of HKEx, said: "The WFE will continue to press for the much-needed reforms in the OTC derivatives market which the G20 governments have set an achievable timetable for central clearing in 2012. We look forward to further progress, and we will be examining results through our meetings and conferences in 2011."


[1] All quotes are from the Tabb study. The emphasizes, if any, are ours.

The complete study is available on the WFE website:



About Romain Devai

Romain started his career in 1995 at the Paris Stock Exchange for the “Nouveau Marché”, the newly created market segment designed for high-growth potential companies. He then joined GL Trade in London in 1998, where he was account manager for major financial institutions active in cash and derivatives trading. In 2000 he became project manager for SelfTrade, a leading on-line European broker. Prior to joining WFE, Romain was senior consultant at CSC (Computer Sciences Corporation). He joined the Federation in 2004 as Research and Projects Manager. Romain graduated from Sciences Po.