The new cost of trading
This report explores how much more expensive cleared and non-cleared OTC derivative transactions will become as a result of the reform package in the EU, how the structure of OTC derivative markets is set to change and what strategic challenges arise for firms.
Over-the-counter (OTC) derivative markets are subject to significant change as global regulatory commitments originating in 2009 take effect. In Europe, the European Market Infrastructure Regulation (EMIR) requires standardised OTC derivatives to be cleared through central counterparties (CCPs); derivatives which cannot be cleared to be subject to bilateral margining arrangements and a strengthened operational risk framework; and OTC and exchange-traded derivatives (ETDs) to be reported to a trade repository (TR). In addition, the Capital Requirements Directive (CRD IV) and the Capital Requirements Regulation (CRR) increase capital requirements for both cleared and non-cleared OTC derivatives.
The scope of the reform is far reaching and covers the five main asset classes: interest rate, credit, foreign exchange (FX), commodity and equity.1 It is clear that costs will increase as a result of these reforms, but the question is by how much and where the burden will fall. This paper addresses the question of how much more expensive OTC derivative transactions will become as a result of the reforms, and estimates the cost impact of the reform package on transactions in the EU.
The case for these changes is based on the argument that the reforms will increase transparency to the regulator and the market, and reduce risk for market participants. We expect the price for this to be an additional total annual cost of €15.5bn for the OTC derivatives market in the EU. We estimate that the incremental costs for transactions that are subject to the clearing obligation will be around €2.5bn per annum. The estimate for transactions that will not need to be centrally cleared is much higher – totalling €13bn annually.
There are three main elements to the costs that will be incurred by OTC derivatives in future: new margin requirements; new capital charges for exposures; and other compliance costs, mainly resulting from additional reporting requirements. This paper provides estimates for the incremental cost for both cleared and uncleared OTC derivatives for the three cost categories and explores some of the reasons for the differences in costs between cleared and uncleared OTC derivatives. In addition to these increases in costs, the market-making dealers may also see revenue fall, e.g. if greater transparency leads to a narrowing of margins.
There are cost implications for all market participants transacting in OTC derivatives: financial counterparties including the market-making dealers; large buy-side customers such as mutual funds, pension funds, hedge funds and insurance companies; and also non-financial counterparties such as industrial companies using OTC derivatives for hedging purposes.