Few OTC derivatives firms ready for reform: Study

NEW YORK & LONDON, June 8, 2011 – Growing at an unprecedented pace, trading in interest rate derivatives represents the largest derivatives asset class in the financial markets. However, despite the fact that 90% of interest rate traders tell TABB Group they utilize interest rate derivatives for hedging, only a small percentage – 27% of these rates traders, including asset managers and broker dealers – have actively analyzed new OTC derivative cost structures, citing regulatory uncertainty as the key roadblock..

These statistics are drawn from TABB’s new benchmark study, “Interest Rate Derivatives 2011: Collateral Damage in the Duration Market,” in which 40% of buy side rates traders say they’re using all available rates products to hedge, including futures, listed options, OTC vanillas, OTC exotics and credit derivatives.

According to E. Paul Rowady, Jr. a senior analyst at TABB and the study’s author, although half of the rates traders believe expected regulatory impacts will be the leading force of change across these markets in the year ahead, only 40% have begun actively preparing for reform measures with the rest carefully monitoring the situation, but otherwise waiting for more finality.

“Although we’re in the early stages of this transformation,” Rowady says, “it’s important to understand how market participants are preparing, what their sense of urgencyis and how they’re operating in the face of uncertainty.Our study found thatthe majority ofbuy side rates tradersare waiting for regulatory clarity before committing resources.”

Despite this uncertainty, he adds, major change is inevitable. “The bottom lineis that new collateral rules are aimed at the jugular: the balance sheet – and both the balance sheet and collateral management issues will become areas of contention between buy-side participants and regulators.”

For sell-side service providers, these balance sheet concerns will become an increasingly important point of innovation on two levels, says Rowady. He explains how the sell side needs to enhance their technical infrastructure and process automation while preserving critical high-touch requirements of these markets. Second, in conjunction with exchanges, CCPs and vendors, they should be devising offerings to counterbalance pressuresthat asset managers will feel in their balance sheets when regulatory changes do occur.

For the buy side, he saysthat if they want to continue to compete in the rates markets – particularly swaps and exotic instruments – asset managers will need to learn how to handle more balance sheet pressure and intrusive reportingrequests.“True, regulatory timelines are still up in the airbut that doesn’t mean the buy side shouldn’t begin preparing now for an era of more collateral costsand stringent reporting demands.”

The 55-page study with 47 exhibits is based on in-depth interviews with 46 senior-level portfolio managers and traders based predominantly in the US and their counterparts on the sellside responsible for OTCmarket-making and fixed income-related offerings. One-to-one discussions covered trading styles,product usage, expected impacts of ongoing financial regulatory reform, preferred risk metrics, brokerselection criteria and trends in trading platforms.

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