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Current Issues Affec ting the OTC Deriva tives

Market and its Importance to London

A pap er produced by

Lynton Jones, Bourse Consult

April 2009



Current Issues Affec ting the OTC Derivatives Ma rket and its

Importance to London is pub lished b y the City of London. The a uthorof this report is Lynton Jones, of Bourse Consult.

www.bourse-consult.com

This paper is intend ed as a basis for d isc ussion only. Whilst eve ryeffort has be en ma de to ensure the a c c urac y and c omp leteness ofthe ma teria l in this rep ort, the autho r, Lynton Jones, and the City ofLond on, give no wa rranty in that reg a rd and ac c ep t no liab ility forany loss or da ma ge incurred throug h the use o f, or relianc e up on,this rep ort o r the informa tion c onta ined herein. The views exp ressedherein are the v iew s of the a uthor and are no t intend ed to exp ressthe views of the City of Lond on C orpora tion.

April 2009

© City of London PO Box 270, Guildha llLondonEC2P 2EJ

http://www.cityoflondon.gov.uk/economicresearch

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Table o f Contents

Exec utive Summa ry 1

1. Introd uc tion 4

2. Size and Sc op e of the Market 5

3. Which Derivatives were the “ Guilty Party” During the Financ ial

Crisis?

7

4. Which OTC Derivatives were not Imp lica ted in the Rec ent

Financ ial Crisis?

11

5. The Future Method of Trad ing and Clearing OTC Derivatives 12

6. Reg ulatory Initiative s 15

7. What Next? 18

8. Conc lusions 20



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Executive Summary

The g loba l OTC Deriva tives market is ve ry large , c onside rab ly large r tha n thelisted eq uity ma rket and the exchange-traded deriva tives ma rket. It is

concentrated largely in the UK, which has 43% by value of the overall market,

and the US which ha s 24%.

The market com prises a b road rang e of different instruments. The most hea vilytraded instruments a re foreign excha nge and interest ra te deriva tives. The

instrume nts wh ic h w ere m ost imp lica ted in the financ ia l c risis we re Co llateralisedDeb t Ob liga tions (CDOs) and struc tured p rod uc ts (SIVs). In ad d ition muc ha ttent ion ha s been foc ussed on C red it Defa ult Swa ps (CDS) which wo uld see m

to have been less hea vily imp lic a ted . Of these, CDS are ac tua lly traded inc onsiderab ly grea ter volume on the OTC d eriva tives ma rket than CDOs.

As a result of the problems allegedly caused by the use of these instruments,

several regulatory bodies and legislators are pushing for the market in theseinstruments to b e more transparent a nd tight ly co ntrolled. This has bec om e ahighly politic ised issue . Although the market in CDS is p rima rily based in the UK,with a sma ller p roportion b ased in the US, the US Treasury Sec reta ry has sa id he

wa nts the ma rket to be run, c leared a nd regu la ted in the US. Co ngress hasintrod uc ed a b ill which see ks to g ive effec t to this desire. Within the US CC Ps(Centra l Counte rparties) willing to c lea r CDS inc lude the C ME and ICE (and ICE

Trust ha s just sta rted c lea ring CDS).

In Europe, the EU Commission has made it clear that it will be looking to imposegreater transparency, transaction reporting obligations and closer supervision

over the OTC m arkets and tha t it is expec ting CDS (and , prog ressively, other OTCtransac tions) to b e c lea red through CCPs. Pressure ha s been put on the industryto c oo pe rate in this end ea vour.

The Fed eration o f Europea n Sec urities Exchanges ha s suggested tha t ha d these

instruments been traded on a public exchange these problems might not havearisen. They sta te tha t these p rod uc ts wo uld b e bette r listed on an excha ngeand therefo re c lea red c entrally. But ma ny OTC prod uc ts a re not suitab le for

trading on a public exchange and they do not need to be listed in order tobenefit from centralised clearing.

For its part, the Futures and Options Association (FOA) has disagreed with this

ap proac h, empha sising ma rket d ifferentiation and the imp ortance of sustainingthe capacity of financial markets in all their different forms to meet the different

and o ften c om plex nee ds of c ustom ers and c ounterpa rties. This view is heldstrongly by the O TC ind ustry itself.



In an attempt to avoid punitive legislation, the industry has committed toCommissioner McCreevy to ensure that by 31 July 2009 as far as possible theseinstruments will be centrally cleared (although this deadline would seem to be

op timistic). The essential issue is where in Europe they should b e c lea red .

The ECB, the Banque de Franc e and the Frenc h Financ e Minister have p rop osedthat a large CCP should be created (possibly from merging some of the existinghouses) within the Eurozone. The ind ustry view and the v iew o f the British

Government is that as the business is essentially global, so a clearing house forCDS should b e g lob a l a lso. In tha t case the b ig Ame rica n c lea rers who a re a lsosetting up in Europ e, in partic ula r ICE, stand a go od c hanc e o f be c oming o ne o f

the de facto global clearers of choice, despite the greater experience ofLCH.Clearnet.

Conclusions

1. The ev idenc e ob jec tively ava ilab le sugge sts tha t the ma jor guilty pa rtiesduring the c urrent financ ial crisis were CDOs on ABS which were sold into highlyleverag ed SIVs he ld by ba nks as off-ba lanc e sheet a ssets. These were va lued b y

the ratings agencies as AAA, a valuation accepted by the banks’ own riskma nag em ent tea ms and not que stioned by the reg ulato rs. While CDOs are

c ertainly de riva tives, for the m ost part they were traded on the OTC d eriva tivesma rket in considerab ly lowe r volumes tha n CDS.

2. The c red it deriva tives wh ic h we re traded most hea vily on the OTCderiva tives market were CDS. There is ve ry little evide nc e to suggest tha t these

c ont ributed in any significa nt wa y to the c risis. Indee d the e ffic ient wa y in which

they we re c losed out d uring the Lehman default sugg ests that they are c apa bleof b eing transac ted safely and sec urely.

3. Notw ithstand ing the evidenc e it seems inevitab le tha t CDS and possibly

even the who le OTC d erivatives ma rket are go ing to be muc h mo re hea vilyregulated as a result of political pressure that “something needs to be done”about the OTC m arket. This politic a l p ressure is ac ute in the Eurozone c ountries

and in the US. In a c c ep ting the inevitab le a dd itiona l reg ulation tha t will c om e, itis importa nt tha t the very suc c essful OTC Deriva tives market is no t c rushed in theprocess.

4. Those a rgu ing tha t OTC p rod uc ts should be mo ved onto exchanges a remistaken. This would b e a n extrem ely foolish mo ve w hich c ould even result indama ge to exc hanges. It is suffic ient tha t OTC p rod uc ts should, as far aspossible, be c lea red c entrally throug h a CCP. This c an hap pen without the

produc ts be ing trade d on a n exc hang e. Given the nature of the market, som eOTC p rod uc ts ma y never be susc ep tible to being c entrally c lea red .

5. The ra tings age nc ies’ c ava lier mo delling, the banks’ ow n over-op timistic

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in-house risk management systems and the slack way in which the regulators

ac c ep ted the views of these p articipa nts we re the m a jor ca uses of the c risis. Thederiva tive instruments tha t we re imp lic a ted were simp ly the p rod uc ts wh ich wereused . This was a c risis c aused by peop le’ s misjudg ment, no t a p rod uc t-led c risis.

6. The OTC deriva tives industry is g loba l. The market will eventua lly dec ide

upon a few de facto global CCPs of choice (concentrating all the risk in onesingle CC P wou ld be too risky). Reg iona l p ressures to c hoose reg iona l CC Ps(whether in the US or in the Eurozone) a re m isguided .



1. Introduc tion

1.1 This pap er has been p rep a red as a c ontribution to the d eb ate c urrentlyunderwa y ove r the d irec tion tha t the future reg ulation of the O TC m arkets should

take. There a re a number of c ont ributors to this deb a te, inc lud ing HM Trea sury,the FSA a nd the Bank of Eng land in the UK, and of c ourse the Europ ea nCo mm ission, spec ific a lly the DG Ma rkt Division he aded by Com missioner Cha rlieMc Creevy and the Europ ea n Central Bank. In the United Sta tes the deb a te is

taking p lac e w ithin the regulatory bod ies, inc lud ing the C FTC (Comm od ityFutures Trad ing C om mission) a nd the Trea sury, but a lso in Co ng ress where a b illhas been introduced (the Peterson Act introduced by the House of

Rep resenta tives Co mm ittee of Ag riculture). The m a in pa rticipa nts in this ma rketa re p rimarily the Inter Dealer Broker c om mun ity (a nd their clients), ba sed for the

most p art in the UK and the US.

1.2 Given the hug e size a nd sc op e o f this ma rket (exam ined in the ne xt sec tion),it has not been possible to undertake a detailed study of the subject in the veryshort time tha t wa s ava ilab le to examine the issue. The metho dolog y follow ed in

the preparation of this report has therefore been mainly based on desk researchplus discussions with a few of the main participants in this debate who wereea sily ava ilab le in Lond on.

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2. Size and Scope o f the Ma rket

2.1 The market in OTC Deriva tives was exp lored in som e deta il in the Bourse

Consult research report for the City of London, “ The Compe titive Imp ac t of

London’s Financial Market Infrastructure”, pub lished in Ap ril 2007. The releva nt

passages desc rib ing the OTC d eriva tives ma rket a re to b e found in paragraphs2.2 to 2.4 of this rep ort. In b rief, the OTC d eriva tives ma rket c an b e d ivided into

three main groups: Financial Derivatives (including Interest Rate and FixedInc om e De riva tives and Cred it Deriva tives), Com mo d ity Deriva tives, and ForeignExcha ng e (FX) Deriva tives. The size o f the ove rall ma rket is enormous. In its latest

triennial rep ort p ub lished in 20071 the BIS estimated tha t the ma rket va lue of OTC

deriva tives c ontrac ts stood a t US$415 trillion, with average d a ily turnove r by Ap ril2007 sta nd ing a t US$2,544 b illion. To a pp rec iate the size o f this market it is worthnoting tha t a t the sta rt of 2007 the m arket va lue of a ll OTC Deriva tives c ontrac tswe re som e e ight times greate r than the eq uivalent excha nge trad ed de riva tives.

We at Bourse Consult estimate that the value of daily turnover in exchangetraded derivatives in London is some 25 times greater than the value of daily

turnover in excha nge trad ed c ash eq uities. This lea ds to the fo llow ing “ invertedpyramid” mo del of the sc a le o f the b usiness (by va lue).

2.2 Within this market, by far the most important products are Interest RateDeriva tives, follow ed by FX. The fo rme r ac c ounted for som e 70% of m a rket va luea t the sta rt of 2007, with FX a t 10%. Both of these showed a slight d ec line from

the p revious stud y und erta ken b y the BIS in 2004 as a result of the rise in trad ing o fCredit Default Swa ps, whic h b y ea rly 2007 had bec om e the third la rge st p rod uc t

trad ed OTC a t 7% of market va lue. Since 2007 this latter sec to r ha s grownc onside rably and the m arket in CDS has be c om e a foc us of a ttention in thewake of the financial crisis (although there is anecdotal evidence that use ofCDS dec lined in the la ter sta ges of the c risis). The to ta l o f all other OTC

derivatives traded (including Equities, Commodities, etc) amounted to just over

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1 Reported by IFSL, in their Derivatives 2007, published November 2007



13%.

2.3 Not only is the overall market huge, but by far the largest proportion of theOTC b usiness is done in the EU, of wh ich the UK is the largest p layer. To q uo te the

IFSL Deriva tives 2007 paper: “ The UK rem a ins the lead ing derivatives c entreworldwide w ith its sha re of turnover sta b le a t 43% in 2007. The US is the only other

ma jor loc a tion with 24% of trad ing.” The a mo unt o f OTC b usiness undertaken inFrance, Germany and Japan combined amounted to less than 15% in 2007.

Another point to note is that the proportion of the industry concentrated in theUK is p rima rily serving inte rnationa l customers. Som e 74% of turnove r generatedby UK-based institu tions is c ross border. Thus the UK is responsible fo r some 47% of

a ll c ross border trad ing, eve n g rea ter tha n its 43% of a ll deriva tives turnover.2

2.4 Since the pub lic a tion o f the BIS triennial rep ort in 2007 and in pa rticular sincethe onset of the financial crisis many more sources of data have been madepub lic as a result of a de sire to inc rea se c onfide nce in the m arket a nd ad dress

c red it issues. As a result it is a lmost c erta inly the c ase tha t the o verall sha pe o fthe market has c hang ed c onside rably. In pa rtic ular we know from a nec dota linforma tion that swa ps volume s have inc rea sed significa ntly. Ad d itiona lly, p rime

brokerage ac tivities have c hang ed c onside rab ly and there is evidenc e tha t thebuy side ha s bec om e very exerc ised about c ounte rparty risks w ith ba nks. It

see ms likely tha t the BIS triennial report d ue in 2010 will show significa nt c hangesin the overall c om position of the OTC m arkets wh ile a t the same time underliningthe preeminence of London as the centre for most of these major markets,

spec ific a lly C DS.

2.5 Therefore there c an b e little doub t tha t no t o nly is the future of this industry of

significa nt importanc e to the UK, but the UK ma rket is of significa nt imp ortanc e tothe g lob al ma rket as a w hole.

2 Ibid - 6 -



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3. Which Derivatives were the “ Guilty Party” During the Financ ial

Crisis?

3.1 There is a w idesprea d percep tion tha t the instrume nts tha t c aused the

greatest problem during the unravelling of the financial crisis, particularly in the

wa ke of the Bea r Sterns and then the Lehm an c ollapse, we re c red it deriva tives.These p rod uc ts we re invente d by JP Morga n in the late 1990s and c om prised

derivatives such as Collateralised Debt Obligations (CDOs) and Credit DefaultSwaps (CDS). The fund amenta l deriva tive which was a t the heart of this c risis

wa s the CDO on asset b ac ked sec urities (henc e CDO o n ABS). Muc h has beenwritten a bout the sec uritisa tion of mo rtgage s and the hug e liab ility tha t this gaverise to when the sub-prime m arket co llapsed . CDOs we re the wa y in which

banks sec uritised m ortga ge s. How eve r, ra ther than be ing heavily traded on theOTC d eriva tive ma rket, many of the CDO instruments we re sold to b anks’ off-

ba lanc e sheet e ntities suc h as struc tured investment veh icles (SIVs), which manyc om me ntato rs have reg arded as the b eg inning o f the real crisis of c onfide nc e in

the ba nks3

.

3.2 The wa y in which CDOs we re sold into the struc tured investment vehic les(SIVs) c aused m a jor p rob lems. Struc tured p roduc ts a re highly c ustomised

instrume nts c om prising fo r the m ost p art C DOs based on asset-bac ked sec urities.SIVs were used by banks as an off-ba lanc e sheet a sset which was essen tially

op aq ue and not transpa rent to the ma rketplac e as a w hole. On the ba sis of theevidence available, it would seem that these instruments, especially the highlyleve raged CDOs on ABS, rea lly were at the c ore of the prob lem . As an examp le

AIG (no tionally an insuranc e c om pany) generate d $500 billion w orth of expo sureon pa per ra ted AAA by the ra tings agenc ies. Positions wh ic h, when written ,

were intended to make three or four basis points ended costing something like800 ba sis points. The und erlying portfolios of a ssets were sub -prime in ma nyc ases, and the ra tings ag enc ies ac c ep ted in their entireity ma thematica l mo de ls

which calculated the chances of loss in these instruments as being extremelysma ll. Ma ny investors we re a b le to leverag e p ositions in these tranc hes byob taining fund ing in ma rkets suc h as the Cana dian 30 da y CP ma rket and when

this and o ther ma rkets failed they ha d to liquida te w ith ca tastrop hic effec ts. Tocompound the problem, the banks exacerbated the rating abuse situation withinsufficient controls to recognise that they were being deceived by their own

market ing hyp e b y op timistica lly va luing risk. The losses involved here a re at theroo t o f a ll bank reva luation of to xic asset issues. Thus, the p rob lem with the use o f

3 FT article “Lost through destructive creation” by Gillian Tett, 10 March 2009



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AIG’ s c orpo ra te referenc ed CDS with a notiona l va lue o f £180 b illion

(representing 48% of total notional value) the actual losses were barely £2 billion(rep resenting only 6% of the to ta l loss). This c om pared with their multi sec torCDO on ABS with a no tiona l va lue of $196 b illion (rep resenting 52% of to ta l

notional value) resulting in actual losses of $31 billion (representing 94% of thetota l loss). In other words while CDOs rep resented just ha lf of the notiona l va luethey rep resented v irtua lly all o f the to ta l loss. Having sa id this it is wo rthme ntioning tha t one o f the reasons the AIG losses on C DS were no t tha t g rea t

wa s be c ause AIG w as effec tively ba iled out.

3.6 The va rious reg ulato ry bod ies involved in this deb a te ha ve c lea rly rea c hed ac onc lusion tha t there need to b e imp rove me nts in the give-up proc ess. Forexample, the ECB and the European Commission seem to believe that the

ab senc e o f any industry-wide give-up proc ess served to exac erba te the effec tsof p artic ipa nts sc ramb ling to g et out of Bea r Ste rns and other CDS. There is a

clear perception that the existing process is far from clear and led to an overallinc rea se in the fea r and c onfusion that was ge nerated at the time. The

regulators have also probably concluded that the market has been skewed toofar towa rds c ontrol by the dea ler c om munity. In the move s under disc ussion itseems c lear tha t the reg ula tors will wish to limit the dea lers’ c ontrol of the ma rketby extending transparency and possibly even governance to the buy-side

participants.

3.7 Thus it is by no mea ns c lear that the simp le existenc e o f these instruments wasthe problem, but rather the extent of a particular firm’s exposure to those

instruments, particularly the CDO market, the extent to which that exposure wastransparent to the marketplace and the fact that the use of these instrumentswa s not supervised by the regula tors and the c entral ba nks. The exposure o f a

firm to the risk involved was compounded by the somewhat cavalier approachtaken by the ratings age nc ies. By effec tively giving a sea l of ap prova l to the useof these highly-leveraged CDOs they enc ouraged the ir use. This must ra ise

fundamental questions about the competence and responsibility of the ratingsagenc ies in the evo lution of the financ ia l c risis. The a c c ep tanc e of these so-

called AAA structured products as good balance sheet investments for banks(and the acceptance of this view by the regulators) was the final nail in thec offin for the banks them selves.

3.8 The c onc lusion tha t one is inesc apab ly d rawn to in the wake of the Lehm andefault is that with the instruments that the market was using, (highly leveraged

CDOs) which were at the centre of much of the associated problems in theclosing out of their positions, the problem was essentially the high leveraging of

these sec uritised p rod uc ts ra ther tha n a c tivity in the OTC deriva tives ma rket.Because they were essentially private transactions between consenting banks

they were not subject to the sort of disclosure that centrally cleared productsenjoy, and this in turn led to a dramatic loss of confidence in the ability ofLehmans and , subseq uently, other banks to ho nour the ir liab ilities. In orde r to



ensure that this sort of thing does not happen again it would seem that whatneeds to be far more heavily regulated is this “over-leveraging” of thesesecuritised products and the role played in their validation by the ratings

agenc ies. In the fac e of this evidenc e the c urrent p ressure for the inc rea sed

reg ulation o f the OTC Deriva tives ma rket a s a whole (see sec tion 6) seems to b esimp ly wrong. This is no t whe re the p rob lems originated . Neverthe less increa sed

reg ulation o f this ma rket now seems inevita b le.

3.9 Given the exac t c irc umstanc es it m ight be mo re c onstruc tive to a rgue that itwa s not the relatively light regula tory reg ime tha t these instrume nts we re sub jec tto (a nd rem em be r that the p artic ipa nts in the OTC m arket a re a s tightly

reg ulated by the FSA a s any other autho rised firm), but ra ther the w ay in whichthey we re used that w as the main problem.

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4. Which OTC Derivatives were not Imp licated in the Rec ent

Financ ial Crisis?

4.1 It is imp ortant not to throw the b aby o ut with the ba th wa ter. A very la rgeprop ortion of OTC d eriva tives had no invo lvem ent wha tsoever in the financ ialc risis. Inte rest Ra te Deriva tives and FX derivat ives, which tog ether ac c ount for

som e 80% of a ll trades in OTC deriva tives, had virtua lly no impac t on the financ ialc risis. Of the rema ining 20%, eq uity deriva tives p layed virtua lly no part andc om mo d ity de riva tives only a sma ll pa rt in the c risis.

4.2 Does this mean that these instruments should be left entirely untouched in thede ba te now und erway ab out the future reg ulation of these ma rkets? Prob ab ly

no t. It is not so muc h the issue o f reg ulation tha t is the p oint but ra the r of fulldisclosure of open positions, that is, the question of market exposure

transpa renc y. Given the extrem ely limited role tha t non-c red it deriva tivesplayed in the evolution of the financial crisis they should really be absolved of

b lame. But in the d isc ussion ab out the future reg ulat ion of OTC derivat ives it isunlikely that these produc ts c an be excluded from the de ba te. In that deb atetheir very limited role should be b orne in mind .



5. The Future Method of Trad ing and Clearing OTC Derivatives

5.1 There is a ge neral c onsensus tha t the existing m etho d of trad ing nee ds to beimp roved a nd the c lea ring of OTC d eriva tives need s to be extende d. Although

several methods exist for a hybrid system of combining electronic trading withtelephone trading there is a general view that telephone trading alone (i.e.without electronic trade processing and confirmations) is an outmoded andineffic ient mea ns of trad ing these c om plex prod uc ts. The industry itself

recognises this and has suggested that there needs to be a wider adoption ofelec tronic trad ing. Alrea dy spo t FX and the ma jor go vernment bond marketstrade elec tronica lly. The industry has suggested tha t the “ elec tronic trad ing of

CDS in North America and of interest ra te swa ps g lob a lly wo uld be a ma jor stepforward for the industry” 6

5.2 The adva ntage s of elec tronic trad ing are significa nt. It imp rove s p ric e

transpa renc y, trade c apture, trade affirma tion a nd c onfirma tion a nd, of c ourse,it makes it much easier for the regulators to track and for the participants toensure tha t they a re fulfilling the reg ulations. There is the refo re little argum ent

tha t this needs to b e enc ourag ed as rap idly as possible.

5.3 There is, howeve r, very little agreeme nt a bout whe ther or not OTC trad ing

should be enc ourage d to mo ve onto an exc hang e platform. The Fed eration ofEurop ean Sec urities Excha ng es (FESE) has pub lished a paper7 which argues

spe c ific a lly that we re the OTC ma rket in CDS etc mo ved onto excha nge s thiswould increase the liquidity and reduce significantly the opacity of the market.They a rgue that excha nge s provide transparent a nd reliab le pric e forma tion

mechanisms, neutrality and independence, robust and appropriate technology,

better regulation and, above all, central counter-party (CCP) clearing andsettlement8. The Futures and Op tions Assoc iation (FOA) on the other hand , while

supporting the ne ed for greater ove rsight of O TC m arkets and increasedtranspa renc y (subjec t to pa ying full reg ard to the nee d for c om me rc ia l trad ing

c onfide ntiality) supported c ontinuanc e o f OTC markets on the b asis tha t theyare complementary to exchange-traded dealings, provide the opportunity oftailored products to meet customer needs which are not necessarily available

from exchange-listed contracts and that the risk is often laid off on the relevantexchange 9.

6 The Future of OTC Markets, by Mark Yallop, COO ICAP, 10 November 20087 Submission to the High Level Group on Cross Border Financial Supervision, 30 January 2009 8 Ibid 9 Letter from FOA to de Larosière, dated 20 February

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5.4 Firstly, exc hanges a re c om plementa ry to the OTC m arkets. The tw o ne ed

ea c h other. Excha nges spec ia lise in highly standard ised p rod uc ts, ma ny ofwhich started life a s an OTC p rod uc t a nd, a s they b ec ame mo re stand ardisedand therefore highly liquid, were c ap ab le o f be ing traded on a pub lic ma rket.

Ma ny of the p rod uc ts c urrently traded OTC a re e ither highly custom ised (e.g.sing le name CDS) or else only sem i-sta nd ardised (suc h as index CDS). It is highlyunlikely that single nam e CDS c ould e ver be sa fely traded on a pub licexchange.

5.5 Sec ond ly the OTC industry be lieves strong ly tha t shifting OTC p rod uc ts onto

exchanges would have a very serious impact on their ability to trade theseproduc ts. For exam ple, in testimony given to the US House o f Rep resenta tives on3 February10 it was stated that “As a policy matter, the purchase of uncoveredCDS p rotec tion is no d ifferent tha n b uying o r selling futures, op tions, stoc ks or

bonds because the relevant product is perceived to be undervalued orove rva lued b y the ma rket. All of these ac tivities a re c ritica l to liquid ity, red uc edexecution costs and efficient price discovery in these markets and all involve

leg itimate and , indeed , desirab le investment ac tivities und er c urrent law . Ab sentthe p a rticipa tion of intermed ia ries and non he dgers, CDS will c ea se to trade in ama rket and they will bec om e e xtrem ely illiquid a nd c ostly, bo th to e nter into a nd

to termina te.... As a d irec t result, lenders and investo rs will be left with far morelimited and mo re expe nsive a lterna tives for manag ing the c red it risks a rising fromthe ir lend ing and investment ac tivities. In turn.... c om panies will have signific antly

reduced access to financing and the financing that is available will be morec ostly. Bank reve nues from lend ing ac tivity will a lso be red uc ed , p lac ing further

p ressure on the financ ia l streng th o f the banking sec tor.”

5.6 Third ly, excha nge s a re d esigned to be a c c essible to reta il as we ll as

who lesa le customers. Tha t is why the leve l of regulation is so tight for exc hang es- it is essentially the re to p rotec t reta il c ustome rs. The OTC d erivat ives marketsare to ta lly wholesa le and it has bee n a ssume d, up un til the rec ent c risis a t least,

that the w holesale c ustom ers a re largely ca pab le o f taking c are of the mselves,henc e the lighter leve l of reg ula tion the markets have enjoyed . The sort of

p rod uc ts being traded OTC wo uld be highly undesirab le for reta il investors.

5.7 Fourthly, the fact that the majority of European exchanges own their own

clearing houses leads them to make the argument that in order to gain accessto centralised clearing and settlement, products need to be listed on a public

exc hange. This is not the case. It has bee n po ssible for a long t ime for OTC

10Testimony by Ed Rosen to House of Representatives on 3 February



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6. Regulatory Initiatives

The US6.1 CDS ha ve bee n trad ed p rima rily in the UK and in the US. In the US, in the

imm ed iate wa ke of the Lehman c ollap se Tim G eithner (who wa s a t the time

president of the Federal Reserve Bank of New York) made a strong statementindica ting his desire to ensure tha t the future OTC C DS ma rket would have to b e

reg ulated , and reg ulated o ut of the US. In the w ake of this sta tem ent the issuehas bec om e a ma jor d isc ussion point in the US Co ng ress. Here the initiative ha sbeen ta ken by the US House o f Rep resenta tives Co mm ittee on Ag riculture

(which is the c om mittee tha t sup ervises the CFTC reg ulator). This c om mittee ha sintrod uc ed a b ill entitled “ Deriva tives Ma rkets Transparenc y and Ac c ountab ility

Act of 2009”, also known as the Peterson Bill, after the chairman of thatc om mittee . The bill, in b rief, p roposes initiat ives for g rea te r transparenc y,ap p rop ria te c entral co unter-party clearing a nd e ffective reg ulato ry oversight. If

enacted in its present form, the bill could have a serious impact on the future ofthe OTC m arkets. Furthermore, it seems p rob ab le tha t the re w ill be a turf wa r in

the US betwee n the va rious reg ulators inc luding the CFTC, the Fed era l ReserveBank a nd the Trea sury.

6.2 The v iew taken b y the Trea sury, now und er Ge ithner, is tha t the entire CDS

ma rket op erate s only in the US and tha t the re should therefore b e a sing levertical clearing and execution venue designated there for the entire globalma rket. But ac c ording to Micha el Gooc h, (Chairma n and C EO of GFI Group)

some 60% of the inter-bank volume in credit derivatives is in fact transactedoutside the US12; of this 60% a very la rge p rop ortion is in fac t trad ed from Lond on(see 2.3).

6.3 US leg islato rs a re taking a c lose inte rest in wha t is going on in the UK and therest o f Europe. A g roup o f US sena to rs visited London e arlier this yea r and had

exte nsive d isc ussions w ith LCH.Clea rnet over the issues invo lved . It see ms c lea r,the refo re, that the US will do its utmost to ensure tha t its reg ulato rs and theTrea sury ha ve the c losest c ontrol ove r the g lob a l CDS ma rket.

Europe

6.4 This determina tion in the US is matc hed in Europe by the desire of t he EUComm ission a nd the ECB to ensure tha t they too have a hand le o n the w ay tha tthe global credit derivatives market is regulated, at least for that portion which

takes plac e in Europ e. Here the picture bec om es mud d ied by d efinitions of

12Writing in the FT, 23 February 2009, “We must act now to avoid a CDS regulatory time-bomb”



what constitutes Europ e. As noted in pa ragrap h 2.3, the va st ma jority of thetrad ing in OTC deriva tives ta kes p lac e in the UK (43%) a nd the US (24%), withFrance a nd G ermany tog ether ac c ounting for only ab out 11%.

6.5 France and Germany are, however, of course within the Eurozone while theUK sits outside. There a re c lea rly mo ves a foo t to loc a te a c lea ring house fo r the

CDS ma rket inside the Eurozone. The first suc h refe renc e w as in a sta teme ntma de b y the ECB in Dec em be r 2008 when the y sa id “ On 18 Dec embe r 2008 the

Go verning C ounc il c onsidered the need to strengthe n the infrastruc ture for over-the-c ounter (OTC) d eriva tives in view of the ir system ic imp ortanc e a ndwelcomed initiatives by the European Commission aimed at introducing

Europ ea n c entral co unterpa rty c lea ring fac ilities for OTC c red it deriva tives. Inline with its ea rlier sta tem ent o f Sep tem ber 2001 on the c onsolida tion of c entralcounterparty clearing and in view of the outcome of the meeting held at the

ECB on 3 Novemb er 2008 (both ava ilab le on the ECB’s we bsite), the Go verningCouncil confirmed that there was a need for at least one European CCP for

credit derivatives and that, given the potential systemic importance of securitiesclearing and settlement systems, this infrastructure should be located within theeuro area” 13. The rea sons g iven by the ECB as to w hy there should be aEuropean solution are that if a CCP defaulted and there was a major liquidityprob lem , the Europ ea n Centra l Bank would no t be p rep a red to rep lac e that

liquidity if the C CP was loc a ted outside the Eurozone. It is a lso c la imed tha tmember state supervisors are reluctant to rely on information-sharing and theoverseas licensing and regulation of foreign clearing houses to the extent that

they will be c lea ring EU CDS. There a re however prob lems with this a rgument,firstly, because closer regulatory cooperation and information-sharing forms a

ma jor pa rt o f US and EU proposa ls for po st-c risis reg ulatory rep a ir; and sec ond ly,

the ECB argument is remote in the extreme because not only did the clearinghouses manage the Lehman’s default extremely well, but there is very little

prec ed ent for c lea ring houses go ing into d efault.

6.6 On 19th Feb ruary, the FT published a rep ort ab out a pa pe r prep ared by theBanque de France which proposed that a clearing house designed for theEurozone be c rea ted . This followed ea rlier suggestions by the Frenc h fina nc e

minister that a ny solution should b e c onfined to the Eurozone. The Banque d eFranc e p aper sta ted tha t “ LCH.Clea rnet’ s dec ision m aking structure is based inLond on a nd this c ould lea d to a n inc rea se in the we ight o f the Lond on financ ial

ma rket o r the reloc a tion of g ove rnanc e to the US if the Paris financ ial ma rkets do

not recommend a solution”14

. The pap er we nt on to prop ose the c rea tion of a

13Decisions tken by the ECB (in addition to decisions setting interest rates) December 2008 14“Banque de France in CDS Clearing Plan” Jeremy Grant, FT, 19 February 2009

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consortium of Eurozone banks looking to develop a common strategy for the

integ ration of severa l of the Eurozone’s p rinc ipa l c lea ring houses. (It is worthrecalling in this context that the UK itself has not been immune from its ownprotec tionist tend enc ies when it prevented c apital flow s to Ice land .)

6.7 Meanwhile the EU Commission in the person of Commissioner CharlieMc Creevy is pushing hard for a Europea n-wide solution. Som e leg islato rs,specifically Pervenche Berès ( a socialist deputy from France), are strongly

promoting the addition of amendments to current legislation going through theEuropean Parliament on the capital requirements directive (CRD) which would

imp ose stringent new c on trols on the OTC d eriva tives market. Ms Berès believesit is only the existence of this threat that led the main banks to write toCommissioner McCreevy on 17 February giving him a commitment to do the

following:(a ) to use o ne or mo re CC Ps in the EU to c lear CC P-elig ible CDS on

Europ ea n refe renc e e ntities and ind ices based on these e ntities, as we ll asba c k-loa ding o utstand ing eligible c ontrac ts;

(b) to resolve within the first quarter of 2009 all outstanding technical,reg ula tory, leg a l and p rac tica l issues in relation to this go a l15.

In theory these ta rge ts a re d ue to b e m et b y the midd le o f 2009. In prac tic e itsee ms dub ious whethe r this very amb itious timeline c an in fac t be m et.

6.8 The m a in prob lem w ith all of these reg iona lly-ba sed solutions is tha t manyprac titione rs c laim tha t a reg ional solution severely undermines the g lob a l natureof the business. David Clark, c ha irman of the Who lesa le Ma rket Broke rs

Assocation (the IDB trade association), while supporting initiatives to increase thec lea ring of a ll OTC p rod uc ts, pointed out the internationa l na ture o f the b usinesswhen he sa id “ An Am eric an or Australian ba nk might trade in a CDS out o f its

London office with an underlying risk that is with a European borrower” 16. Theforma l position o f the UK is c lea rly set out in the Cha nc ellor’s lette r of 3 Ma rc h tothe Czech Presidency17, g iving his response to the de Larosière rep ort. In it hesta tes: “ It ha s a lwa ys bee n c lea r tha t the fina nc ial service s industry is g loba l..... EUarrang em ents need to fit with global p rac tic e. We must a lwa ys c onside r how our

EU a rc hitec ture ma tc hes tha t of our interna tiona l c ounte rpa rts...” He goe s on:“ The d eve lop me nt o f rules for c lea ring a nd settlem ent system s in pa rticularshould b e a p riority....Just as a b ank from any Mem ber Sta te c an offer ac c ounts

15 Letter to Commissioner McCreevy re: Industry Commitment to the European Commission regarding Central CounterpartyClearing of Credit Default Swaps in Europe. 16 “Battle shapes up for credit derivatives clearing”, Jeremy Grant, FT, 17 March 2009 17 Letter “European Financial Regulation and Supervision”, 3 March, Alastair Darling to Czech Minister of Finance



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7. What Next?

7.1 There a re a numb er of c lea ring houses which have a lrea dy indicate d thatthey intend c learing CDS or alrea dy offer som e kind o f servic e. These inc lude in

the US, CME (reg ulate d by the CFTC) and ICE Trust (regulate d by the New York

Fed), and in Europe NYSE LIFFE in conjunction with LCH.Clearnet, CME, ICE andEurex Clea ring. Note tha t the DTCC in the US ac ts as a w arehouse inside w hich

trades sit and it is a utility tha t a ll CCPs w ill use. If it purchases LCH.Clea rnet , as ithas indicated it wishes to do - although this is now looking less likely given theintervention of othe r parties - it would also b e ab le to a c t as a C CP. But even

then the other CCPs would be ab le to ac c ess it as NYSE LIFFE, ICE and CM E ha vealrea dy agreed . It seems c ertain that whate ver c om es out of the EU

Commission, there will be a requirement for these products to be cleared andreg ulated on a CC P based w ithin Europ e. Franc e and Ge rmany will a lmo stc ertainly w ish to use the UK’s absenc e from the Eurozone to a rgue tha t a single

large CCP should be set up within the Eurozone and - just possibly - try tointrod uc e leg islation requiring tha t a ll trades pass throug h tha t CCP.

7.2 It is nec essary at this junc ture to add a note of c aution. At a time w hen the reis a rush to ensure that everything must be centrally cleared, it is important torec og nise tha t not everything c an be c lea red nor will all c ounterpa rties be ab le

to c ollate ra lise in cash (versus the flexibility of OTC c ollate ral prog rammes andbanking relationships). OTC m arkets a re a n inc uba tor and suffer (and will a lwa yssuffer) from poor pricing transparency and wide spreads when they first start

trad ing . Clea ring b y co mp arison relies on c onfide nc e in its p ricing and va lua tionac c urac y. Therefore a rush to c learing tha t end s up w ith a CCP failure would b e

worse tha n the situat ion tha t exists right no w. Users’ c onfidenc e in CCPs must bevery high if they are to enjoy reduced capital charges and low expectations of

defa ult. Survivo r loss mutua lisa tion, as op posed to a user prefund ing the ir ow npotential default via initial margin payments to a CCP, undermines the creditva lue o f a CC P by forc ing users to reserve c ap ita l aga inst the p rospec t of a C CPfailure.

7.3 It is worth exam ining b riefly the c laims of t hese various CC Ps. Firstly a g loba l

ma rket need s a g lob al c lea rer. In the c ontext of the OTC m arkets that m ea ns aCCP tha t ha s expe rienc e o f c lea ring in the UK and in the US, and to a lesserextent in the Eurozone. Sec ond ly the industry is c onc erned to ensure tha t

whichever CCP becomes one of the de facto CCPs of choice operates as autility ra ther tha n a fo r p rofit entity. Third ly it is self evident tha t the C CP needs to

be experienc ed a nd c ap ab le of hand ling crises. How d o eac h of thec and ida tes fit into these c a tegories?

7.4 LCH.Clea rnet has perhap s the grea test experienc e in the c lea ring o f OTC

prod uc ts. This expe rienc e has been ga ined b y alrea dy clea ring va rious OTCprod uc ts in the UK and the rest of Europ e, and in the US. In c onjunc tion with



NYSE Liffe it has launc hed B-Clea r which is a lrea dy capab le of c lea ring CDS (butwh ic h has a t the time o f writing not yet c lea red a single CDS). It has a la rge a ndexperienced risk management staff and has successfully handled major defaults

suc h as Barings, LTCM a nd Lehmans. It is a lso (fo r the time being a t least)

mutua lly owned . In the US, ICE Trust wo uld see m to be the lea d ing c and ida te(and in its first month o f op era tion - March 2009 - ICE Trust c lea red 613 CDS

transac tions rep resenting $70 b illion of notiona l va lue). How ever, it ha s bee ninvolved in c lea ring fo r just ove r a year. Note , when it purc hased the New York

Boa rd o f Trad e in Janua ry 2007 it a c quired NYBOT’s c learing unit and it has usedthis as the basis for clea ring its exchange t raded p rod uc ts in the US, Canada andthe UK. In the UK it had to hire fo rmer LCH sta ff to set up its Europea n op era tion.

ICE Trust ha s the bac king of ten m a jor US banks. It is a for profit en tity and no t autility. The CME group is a lso see king to enter this spac e. It has c onside rab leexperience of clearing exchange traded products but none at all of clearing

OTC p rod uc ts. It too is a for profit ent ity and ac c ording to la test rep orts is havingd iffic ulty in finding bac kers (and , as a result, ha s delayed sta rting its CDS c learing

servic e d esp ite ha ving rec eived reg ula tory ap prova l). Within the Eurozone, onlyEurex Clea ring has the b ac king to set up an OTC c learing o peration. It intend ssta rting the c learing of C DS within the next month o r so.

7.5 Given the m ultip licity of c lea rers em erging, ultima tely it w ill be the m arket tha t

de c ide s which o nes be c om e the d e fac to c lea rers of c hoice (ab sent d istortionsc aused by leg islative fia t). Tha t b eing so, g iven the support of the b ig US banks itsee ms a t lea st a strong possibility tha t ICE Trust w ill sta nd a bet ter chanc e o f

succeeding as a supplier of a global solution than European clearers without astrong US p resenc e. But throug h its link with NYSE LIFFE, LCH.Clea rnet c an c laim

to ha ve a US p resenc e. And through its ow nership of the former Frenc h CCP

Clea rnet it can also c laim to b e in the Eurozone. Eurex Clea ring sta rts from thed isadva ntage of not ha ving a significa nt US p resenc e.

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8. Conc lusions

8.1 It should, hop efully, be e viden t from wha t ha s been sa id in this paper that theOTC d eriva tives business is of ve ry signific ant imp ortanc e to the City of London .

No-one wo uld w ish to sugg est tha t in the w ake o f the financ ia l crisis this sec tor of

the financial services industry should be protected from the wave of increasedreg ula tion tha t is now inevitable. But in the impleme ntation of tha t mo re onerous

reg ulation, and spec ific a lly in the fa c e o f the fac t that the UK fac es c onside rablechallenges because it is outside the Eurozone, it is to be hoped that theimportance of ensuring the long term health of this very important industry is

borne in mind. In writing this paper I have rea c hed a num ber of conc lusions.They a re, of c ourse, entirely persona l.

1. The evidenc e ob jec tively ava ilab le sugge sts tha t the ma jor guilty pa rties

during the c urrent financ ial crisis were CDOs on ABS which were sold into highlyleverag ed SIVs he ld by ba nks as off-ba lanc e sheet a ssets. These were va lued b ythe ratings agencies as AAA, a valuation accepted by the banks’ own risk

ma nag em ent tea ms and not que stioned by the reg ulato rs. While CDOs arec ertainly de riva tives, for the m ost part they were traded on the OTC d eriva tivesma rket in considerab ly low er volumes tha n CDS.

2. The c red it deriva tives wh ic h we re trad ed mo st hea vily on the OTCderiva tives market were CDS. There is ve ry little evide nc e to suggest tha t thesec ontributed in any significa nt wa y to the c risis. Indee d the e ffic ient wa y in whichthey we re c losed out d uring the Lehman default sugg ests that they are c apa ble

of b eing transac ted safely and sec urely.

3. Notw ithstand ing the evidenc e, it seems inevitab le tha t CDS and possibly

even the who le OTC d erivatives ma rket are go ing to be muc h mo re hea vilyregulated as a result of political pressure that “something needs to be done”

about the OTC m arket. This politic a l p ressure is ac ute in the Eurozone c ountriesand in the US. In a c c ep ting the inevitab le a dd itiona l reg ulation tha t will c om e, itis importa nt tha t the very suc c essful OTC De riva tives market is no t c rushed in the

process.

4. Those arguing that OTC p rod uc ts should b e mo ved onto excha nge s a remistaken. This would b e a n extrem ely foolish mo ve w hich c ould even result indama ge to exc hanges. It is suffic ient tha t OTC p rod uc ts should, as far as

possible, be c lea red c entrally throug h a CCP. This c an hap pen without the

produc ts being trade d on a n exc hang e. Given the nature of the market, som eOTC p rod uc ts ma y never be susc ep tible to being c entrally c lea red .

5. The ratings age nc ies’ c ava lier mo delling, the banks’ ow n over-op timistic

in-house risk management systems and the slack way in which the regulatorsac c ep ted the views of these p articipa nts we re the m a jor ca uses of the c risis. The

otc derivatives report v 21

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