The International Swaps and Derivatives Association (Isda) fears that mandatory clearing for over-the-counter (OTC) equity derivatives could result in trading volumes moving to the exchange-traded market, curtailing the role for the OTC contracts in risk management.

According to Isda research released on Tuesday, the equity derivatives market is uniquely varied in terms of the factors that influence investment and hedging decisions and it is important to understand the different product characteristics, as well as how standardised, exchange-traded futures and options contracts differ from the highly customised contracts traded in the OTC market.

“The vast majority of the equity derivatives market is already cleared, including all listed futures and options contracts,” it said. “This capability is likely to continue to naturally increase over time, capturing those products with the most standardised product terms, in the most popular maturities and referenced to the most liquid stocks and indices.”

However, the industry body said that the broad availability of clearing for OTC equity derivatives products will not develop overnight and is likely to remain limited in the near future, largely because of the highly tailored nature of these instruments, and the complex, non-standard adjustment events such as corporate actions that are negotiated between counterparties.

“While demand for clearing is likely to gradually build for more standardised/commoditised OTC products, it will be challenging to develop clearing solutions in the near future for OTC products such as equity swaps, OTC single-name options and exotic equity products,” said Isda.

OTC v exchange
According to Isda, OTC contracts meet an important need, as they allow non-financial counterparties, asset managers, pension funds and other end-users, as well as banks, to meet their investment objectives and hedge very specific, business-critical risks.

“The size of the OTC market, despite the existence of a listed, standardised and clearable equity derivatives market, proves these instruments continue to have an important role in the equity derivatives market,” it said.

European legislators such as the European Securities and Markets Authority (Esma) have recognised the importance of customised, non-clearable OTC contracts that enable end users to manage risk and achieve their investment objectives, and have drafted regulatory technical standards on risk mitigation techniques for non-cleared OTC derivatives.

However, Isda said that although the new rules mean that non-cleared trades will be subject to margin requirements to mitigate associated risks the calibration of these requirements will be important to ensure the continued availability of these products, given the absence of cleared substitutes.

Granular approach
“Any clearing obligation decision should consider the unique features of listed and OTC instruments, as well as the specifics of individual products,” Isda said. “The cleared futures contracts available on Bclear, for instance, are very different from OTC equity forwards and swaps.”

According to Isda, under current rules, these instruments would all be captured under the same bucket, potentially leading to circumstances where a clearing mandate is applied to that entire class, despite an absence of demand for clearing and no existing clearing service for OTC equity swaps.

“An overly broad clearing mandate based on underlying, product type or settlement currency – for example, options on European equities – would also be disruptive, potentially capturing contracts for which no clearing service exists,” said Isda.

The industry body said that a granular approach to evaluating whether products should be cleared, including a detailed product taxonomy, a comprehensive review of liquidity and analysis of product standardisation, is vital to the process.

“This will ensure additional operational hazards are not introduced to the market, and CCPs do not have the opportunity to improperly benefit from a clearing monopoly in certain products,” it said.

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