Growing at an unprecedented pace, interest rate derivatives represents the largest derivatives asset class in the financial markets. However, despite the fact that 90% of interest rate traders tell Tabb Group they use interest rate derivatives for hedging, only a small percentage – 27% of these rates traders, including asset managers and broker dealers – have actively analysed new over-the-counter (OTC) derivative cost structures, citing regulatory uncertainty as the key roadblock.
These statistics are drawn from Tabb’s new benchmark study, ‘Interest Rate Derivatives 2011: Collateral Damage in the Duration Market’, in which 40% of buy-side rates traders say they’re using all available rates products to hedge, including futures, listed options, OTC vanillas, OTC exotics and credit derivatives.
According to E Paul Rowady, Jr a senior analyst at Tabb and the study’s author, although half of the rates traders believe expected regulatory impacts will be the leading force of change across these markets in the year ahead, only 40% have begun actively preparing for reform measures with the rest carefully monitoring the situation, but otherwise waiting for more finality.
“Although we’re in the early stages of this transformation,” Rowady said, “it’s important to understand how market participants are preparing, what their sense of urgency is and how they’re operating in the face of uncertainty. Our study found that the majority of buy-side rates traders are waiting for regulatory clarity before committing resources.”
Despite this uncertainty, he adds, major change is inevitable. “The bottom line is that new collateral rules are aimed at the jugular: the balance sheet – and both the balance sheet and collateral management issues will become areas of contention between buy-side participants and regulators.”
For sell-side service providers, these balance sheet concerns will become an increasingly important point of innovation on two levels, said Rowady. He explains how the sell-side needs to enhance their technical infrastructure and process automation while preserving critical high-touch requirements of these markets. Second, in conjunction with exchanges, central counterparties (CCPs) and vendors, they should be devising offerings to counterbalance pressures that asset managers will feel in their balance sheets when regulatory changes do occur.
For the buy-side, Rowady said that if they want to continue to compete in the rates markets – particularly swaps and exotic instruments – asset managers will need to learn how to handle more balance sheet pressure and intrusive reporting requests. “True, regulatory timelines are still up in the air but that doesn’t mean the buy side shouldn’t begin preparing now for an era of more collateral costs and stringent reporting demands.”
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