One of the great misconceptions about financial reform is that over-the-counter derivatives volume will shrivel. In fact, volume will continue to grow. Yet these reforms will be disruptive, shifting power and revenue away from dealers and creating enormous opportunities for those new entrants that can quickly adjust their strategies and differentiate their capabilities.
A key purpose of the Dodd-Frank Act is to "de-risk" the OTC derivatives market, to shift the industry away from a bilateral model — where two counterparties privately decide on pricing and margins — to a transparent cleared model where risks are more visible and measurable. To this end, the financial reform requires broad clearing through central counterparties, choices in swap execution and stringent collateral requirements.
Though these changes are dramatic, we don't believe they will significantly change the size or, indeed, the importance of the OTC market.
Our company estimates that from 2010 to 2013 the notional outstanding volume of the OTC derivatives market will grow from $350 trillion to $435 trillion, reaching pre-reform levels. Equally important is that this revenue will be reallocated, creating opportunities for a broader set of market participants to compete in the derivatives market. Financial reform won't diminish the market's volume or revenue, but it will change where that revenue is coming from and who can potentially capture it.
In advance of reform, market making by broker-dealers has generated virtually all revenue in the OTC derivatives market — about $22 billion in 2010. The spread for dealers included charges for market making, clearing and execution; however, there was no transparency of the components. The spread will drop markedly after reforms go into effect, by more than 50% (as much as $10 billion by our estimates) due to greater price transparency and the replacement of exotic, highly structured instruments with standardized contracts. But that revenue won't be lost; it will be reallocated to other services mandated by financial reforms. Derivatives clearing, central counterparty, electronic swap execution and collateral management could generate up to $12 billion in the near future.
These four functions, intended to bring transparency to the market, represent a significant opportunity. All the major market players will be jockeying for market share.
Success will depend on how well they adjust their strategies. We recently conducted a survey of sell-side broker-dealers and buy-side firms to gain some insight into how best to adapt to the new OTC derivatives environment.
Derivatives clearing: The new rule that major swap participants must clear a majority of "eligible" contracts is a significant opportunity for participants willing to be an intermediary between the buy side and central counterparties. To capitalize on this opportunity, a market player needs operating and processing efficiency, as well as top-notch risk management. Revenues will come from clearing fees, servicing fees and net interest income. Key buy-side needs include balance-sheet strength; post-clearing processing; breadth of offerings; front-office services; neutrality; and competitive fees.
Central counterparty: The expected increase in centrally cleared swap trades creates an opportunity to manage counterparty risk. Incumbent players with broad product offerings and risk management capabilities have an advantage in this market and will generate revenue through clearing fees, servicing fees and net interest income. Key buy-side and sell-side needs include competitive scale and fees, as well as neutrality to prevent conflicts of interest.
Electronic swap execution: The Dodd-Frank law calls for a "swap execution facility" to execute clearable swaps. Firms can capitalize on the mandate for choice in execution venues by launching e-trading platforms to match counterparties and generating revenue through execution fees. Buy-side and sell-side participants require certainty of execution in terms of both volume of bids/offers and liquidity providers.
Other client needs include low-latency technology, so fund managers can rapidly move in and out of positions; competitive fees; breadth in instruments that can be e-traded on a single venue; risk monitoring; and portfolio analytics tools.
Collateral management: The new rules require all market participants to post collateral on all swap transactions. Given the increase in the number of counterparties that buy-side firms must engage, there will be a need to manage and track collateral. Commission revenues will be based on total collateral posted. This market will favor custodians with broad margining and reporting capabilities. Key buy-side needs include breadth of assets to enable a one-stop shop for collateral management, reporting, collateral flexibility and margining.
Winning in any of these four areas won't be easy, but the opportunities in the OTC derivatives market are significant — and they are fast approaching.
