Why OTC is back in vogue

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In the world of fashion, they say trends from years ago always come back. Well, the same is true in the not quite so glamorous market of over the counter (OTC) derivatives. Seven years after the crisis, the same contracts once more vilified than a Supermodel’s waist size are once again the talk of the street – that’s Wall Street not the high street.

A study by the Bank of International Settlements (BIS) shows that market value for OTC derivatives increased from $17tr to $21trn between June and December last year – their highest level in three years. But what’s driving this renewed interest and who will reap the rewards?

You can’t answer this without first considering the deluge of regulations that has rained down on the industry. From Dodd-Frank to Mifid I/II, the main concern for fund managers whether large, mid-sized or small, has been finding ways to comply. This has led to a boom in compliance officers on six figure salaries and widespread adoption of technology and infrastructure tools. All because every aspect of a fund’s performance is now under the microscope.

As a consequence of having to conform to the same rules, firms across the spectrum have been adopting similar risk averse trading strategies. Therefore, it has become far harder for firms to differentiate themselves. But with regulatory houses now in order and confidence rising, many are now turning back towards what they do best – increasing margin and profit. Hence the re-emergence of OTC. And in an attempt to steal a march on the competition, the latest buzz is around Contingent Convertible Bonds, more commonly known as CoCos. Unlike CDOs and CDSs, which are now so 2008, CoCos are recognised for preventing systemic risk.

For the tier ones with large resources, refocusing trading strategies to incorporate these new products is hardly a tall order. And at the other end, while they may not have the resources, the boutique players have the flexibility to adjust their trading models. However, it’s somewhat of a different situation for funds operating at the top end of the middle tier. They simply don’t have the manpower or the capital of a tier one, and they aren’t as nimble as a smaller player.

The upshot is that these midsized firms need to review operations with a view to cutting costs. Only then will they be able to deliver the scale needed to support new OTC strategies – otherwise they risk falling behind.  This is no easy task, which is why firms are looking for systems that can remove the headache of managing complexity. Whether that’s operating multiple asset classes to consolidate, control and manage risk, or satisfying the reporting demands of regulators. Having infrastructure in place to handle all this frees fund managers up to focus on devising the best possible trading strategies in order to compete.

Despite the recent rise, it’s hard to say whether we are at the start of a longer term move back to OTC. Capital adequacy, clearing, collateral and margin pressures means derivatives are unlikely to deliver pre-2008 levels of profitability. But as long as there’s some profit to be made one thing’s for certain; successful fund managers will be the ones with the right systems to handle any returning volumes – regardless of the latest OTC instrument in vogue.

 

Edward Lopez is vice president, EMEA at OpenLink

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