In September 2009, the European Central Bank (“ECB”) released a report entitled OTC Derivatives and Post-Trading Infrastructures (the “Report”). In 2008, the ECB launched an analysis of the over-the-counter (“OTC”) derivatives market and its infrastructure for the primary products entered into in the marketplace (i.e., interest rate swaps, equity derivatives, credit default swaps, foreign exchange derivatives and, although they are not typically categorized as derivatives, repurchase agreements). This analysis, which focused on the euro-segment of the market, was initiated as a result of concerns over the limited development of post-trading infrastructure for these products, particularly against the backdrop of the recent financial turmoil, and its possible effect on the euro area. The Report presents the main findings of this analysis, including a summary of the general market characteristics and the current state of post-trading infrastructure, and discusses the policy implications relating to its findings.
The Report first describes each of the product types and its characteristics. Relying largely on data from the Bank for International Settlements, it also identifies banks and other financial institutions as the main market participants in OTC derivatives by product. The Report places great weight on what it views as the systemic relevance of the OTC derivatives markets “in particular because of the existence of large exposures between a limited number of financial institutions.”[1] Among other things, the Report points out that the web of interdependencies related to OTC derivatives between the market-making dealers means that disruptions at one such dealer may easily be transmitted to others, as well as to the wider financial system.
The Report then discusses the three phases of the post-trade processing of OTC derivatives: (i) pre-clearing, (ii) clearing and (iii) settlement. The pre-clearing phase mainly involves trade confirmation and matching services. The Report notes that, according to recent data, approximately 50% of OTC derivatives continue to be confirmed on paper. The profound spike in volume of these trades has resulted in delays in confirming transactions which, in turn, has weakened the enforceability of trades, hampered the ability of trade counterparties to net their exposures and increased the risk of incorrect book-keeping (which could lead to an incorrect measure of counterparty credit risk). The Report further notes that OTC derivatives are still predominantly cleared through bilateral arrangements, as opposed to centrally. Finally, the Report discusses the predominant existing methods of periodic settlement for OTC derivatives.
The Report notes that there have been numerous recent industry efforts in the area of electronic trade processing and matching services. It also acknowledges that the urgent push by regulators and market participants to establish central clearing counterparties, particularly for the credit default swap market, has led to progress in the development of such entities. However, it concludes that the market coverage of existing post-trading infrastructure for OTC derivatives is by no means comprehensive.
In sum, the Report findings highlight the systemic relevance of the OTC derivatives market owing to its size and to the central role of major financial institutions in its trading activities. The findings also underscore the importance of the euro currency in these transactions and the significant share of market participants located in the euro area. The Report concludes that its findings point to two main policy implications: (i) the importance of developing post-trading infrastructure to support the safe, efficient and transparent functioning of the OTC derivatives markets and (ii) the need to accompany the development of post-trading infrastructure for OTC derivatives with close cross-border cooperation among the relevant competent authorities.
[1] Report, at 12.