Firms currently in the midst of implementing the European Market Infrastructure Regulation (EMIR) will be left with little doubt that the cost of doing business in over-the-counter (OTC) derivatives is set to increase. But to date there has been little clarity as to the size of the increase in costs and how they will differ for a cleared trade versus a non-cleared trade. In our paper 'OTC Derivatives – The new cost of trading', we explore how much more expensive cleared and non-cleared OTC derivative transactions will become as a result of the EU OTC derivative reform package; how the structure of OTC derivative markets is set to change; and what strategic challenges arise for firms.
We have estimated that the reforms may lead to an additional total annual cost of €15.5bn for the OTC derivatives market in the EU. The cost increases for non-centrally cleared transactions are estimated to be substantially higher than for centrally cleared OTC derivatives. Additional costs for transactions that will not need to be centrally cleared are expected to amount to €13bn annually, compared to €2.5bn for OTC derivatives that fall under the clearing obligation.
Differences in additional cost between cleared and non-cleared OTC derivatives are even bigger if the estimated costs are applied to the notional amounts of OTC derivatives outstanding in Europe. The costs for centrally cleared OTC derivatives are set to increase by €13.60 per €1m notional, while additional costs for non-cleared transactions are estimated to amount to €170.50 per €1 million notional amount – more than twelve times the increase for cleared OTC derivatives. To put this into context, this will mean an increase of €1,428 per transaction for the average cleared interest rate derivative and €14,492.50 for non-cleared.
It is not only the magnitude of cost increases, but also their composition that varies between cleared and non-cleared OTC derivatives. For transactions that will need to be cleared, margin requirements are the main driver of the additional costs. Here we estimate that margin requirements account for €10 per €1m notional, including additional clearing fees and contributions to the CCP default fund. For non-cleared OTC derivatives, new capital requirements will be the biggest cost element. Additional annual costs arising from CVA capital charges for non-cleared transactions are estimated to be €120 of the €170.50 increase per €1 million notional. Compared to margin requirements and capital charges, the third block of costs – incremental costs arising from new reporting requirements and other compliance costs such as account separation and record keeping – is expected to be relatively small. We estimate these costs to be approximately €0.60 per €1m notional for cleared and €0.50 for non-cleared OTC derivatives.
The impact of the increased costs is expected to manifest itself in a number of ways. First, some banks may decide that non-cleared products are too capital intensive and look to focus offerings in standardised products. Second, as a result of the new increased costs we could see end-users looking to buy less perfect hedges by using cleared/standardised OTC derivatives in place of more bespoke and more expensive non-cleared derivatives, ultimately leaving more risk on their own balance sheets. Third, we may see financial and non-financial counterparties look for alternative products, for example in the futures market where margin requirements are lower.
As a result of increasing costs of doing business in OTC derivatives, firms active in the market will review margining practices and, if applicable, the capital efficiency of products. We expect banks to respond to the challenges in an innovative and competitive way. Firms will review product lines and restructure their offerings as appropriate, possibly adding new, more capital efficient products. The large dealer banks may opt for more defensive strategies in order to prevent general erosion of their client base and protect higher-margin product lines. Smaller firms on the buy side may be the ones that find OTC derivatives in the new environment too expensive and will move to cheaper, more standardised, cleared products to a larger extent. But it is clear that OTC derivatives markets will under-go significant change for some time to come.
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