Standardisation ‘a must’ for uncleared swaps

With the bilateral margin regime beginning in September, the key to the future of the uncleared derivatives market is the standardisation of swap products and terms, according to trading executives.

A new initial and variation margin regime for uncleared trades will be phased in from September 2016, requiring counterparties to update their credit support annexes to comply with the new requirements. In an interview with Risk.net yesterday, International Swaps and Derivatives Association chair Eric Litvack said this could be an opportunity to bring standardised terms into the uncleared market, thereby resolving end-user concerns about embedded costs.

Litvack's views were backed by Jonathan Hunter, global head of fixed income and currencies at RBC Capital Markets, speaking on a panel at Isda's 31st annual general meeting in Tokyo today (April 13).

Hunter pointed to the split that has already occurred between the standardised cleared swap market and its more bespoke, uncleared variant. He said this was likely to be replicated within the uncleared sector, with standardised terms becoming the norm as firms sought to reduce the costs and charges to end-users in this sector.

"The future of the derivatives market [is] standardisation right across the board. We've seen a large split between standardised, cleared, swap execution facility (Sef)-executed trades and non-cleared, bilaterally executed transactions, products and terms over the past two or three years. We will continue to see standardisation win that battle."

End-users often use bespoke, uncleared derivatives products to more precisely match their risks. However, the collateral agreements underpinning these contracts can also include idiosyncratic terms – for instance, specifying a particular type of eligible collateral for variation margin, or how interest payments on posted margin should be treated when rates go negative. This embedded optionality is increasingly being priced into new trades, and needs to be risk managed.

"Every non-standard term that we engage upon as an industry means resources need to be deployed to manage second-order risks associated with that non-standard term. And just think about whether or not we can redeploy those resources to other areas and allocate more resources to liquidity – or better yet to client-facing type initiatives – that's a very positive development. So that's a bit of a call to arms as it relates to standardisation."

Hunter said a move to more standardised products could also pave the way for the growth of new market participants in the uncleared swap market. Non-bank market maker Citadel Securities, for example, has experienced huge growth in the highly standardised cleared US dollar interest rate swap market, taking top spot across a number of metrics on Bloomberg's Sef and being named Risk's 2016 interest rate derivatives house of the year.

"Standardisation enables new entrants to enter the marketplace, which is bringing in a new perspective," he said.

Richard Prager, head of the trading, liquidity and investments platform at asset manager BlackRock, who was speaking on the same panel, said the whole derivatives market will inevitably have to move to a more standardised model, where benchmark products are traded and trades with entity-specific terms are limited.

"The industry has absolutely no choice but to really look at what will be the benchmark products, so that they can go around and transact in them. It means we will no longer have the luxury of bespoke. It really will be the corner case. The more things that can be standardised [the better], whether it's products or definitions, so it's a must for the industry," said Prager.