Rising costs, regulation altering derivatives landscape: Fitch

Notional value of credit derivatives has fallen by 40% in three years

Fitch Ratings Fitch Ratings

The following is from Fitch Ratings...

CHICAGO--(BUSINESS WIRE)--The introduction of centralized derivatives clearing under the Dodd-Frank Act (DFA) in the U.S. will raise transaction costs for all participants in derivatives markets, and end users of hedging instruments will likely face higher collateral requirements, according to a new Fitch Ratings report.

As the largest U.S. users of derivatives prepare for significant changes in the regulatory environment, the outstanding notional amount of derivatives has remained roughly steady since 2009, at approximately $300 trillion for the largest 100 U.S. market participants. Interest rate swaps ($237 trillion outstanding) continue to drive the bulk of global derivatives activity. However, the notional amount of credit derivatives outstanding has fallen by 40% over the last three years to approximately $22 trillion as of year-end 2011.

We expect broader regulation of swaps market participants and dealers to drive costs higher over the next few years as over-the-counter activity migrates to central clearing through multiple derivative-clearing organizations (DCO) in the U.S. and overseas. Regulations will result in higher reporting and infrastructure-related costs tied to this migration, in addition to new collateral and margining requirements.

The greatest impact will be felt by financial institutions, as they will likely clear swaps through DCOs, reducing their ability to net within counterparties. This will likely increase collateral requirements and total net derivative exposure. In addition, increased collateral requirements will likely constrain systemic liquidity, absent any other changes. We expect that much of the increased costs tied to higher collateral requirements and reduced liquidity will be passed on to many nonfinancial users of derivatives.

Central clearing will allow regulators to aggregate systemic exposure and identify those counterparties with the largest derivative positions. Financial institutions may be exposed to higher margin or collateral requirements as regulators and DCOs look to mitigate counterparty risk through changes in initial and variation margin rules, as well as the types of eligible collateral to be posted.

Six large financial institutions continue to account for more than 75% of all derivative assets and liabilities carried on the balance sheets of 100 firms reviewed by Fitch in our survey of derivatives activity. They also account for 98% of the total notional amount of derivatives outstanding. The six firms are JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, Morgan Stanley, and Wells Fargo.

For a detailed survey of derivatives and pending regulation, including a review of positions held by the top 100 corporate derivatives users, see "Derivatives and U.S. Corporations," dated June 7, 2012, at www.fitchratings.com.

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