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July 13 (Bloomberg) -- The market for interest-rate and credit-default swaps will grow more than 10 percent to $435 trillion by 2013 as oversight of over-the-counter derivatives improves price transparency and cuts trading risk, according to Citigroup Inc.
Banks, hedge funds and other investors are bracing for sweeping changes to the private derivatives market, including increased capital requirements and most trades being processed by clearinghouses, which require margin payments. The Dodd-Frank Act, passed in the U.S. last year, and rules being created now by the European Parliament will regulate swaps for the first time in their 30-year history.
“Notional values in derivatives (especially interest-rate swaps and credit-default swaps) are expected to rise, due to increased transparency and counterparty risk mitigation,” Citigroup’s Mike Sleightholme, global head of hedge fund services, and Bikramjit Singh, global head of OTC derivatives services, wrote in a report released today, citing internal analysis from the New York-based bank.
Combined interest-rate and credit-default swap notional values totaled $394.3 trillion as of December, according to Bank for International Settlements data. The $601 trillion private derivatives market also includes foreign exchange, equity and commodity derivatives.
The Commodity Futures Trading Commission has said it hopes to finish its rule writing by year-end, a delay from the initial goal of July after banks, investors and the commission agreed that more time was needed. The Securities and Exchange Commission is also writing regulations for the parts of the market it will oversee.
Hedge funds and money managers, the so-called buy side, will need to prepare for the coming changes to curb the costs of doing business, the report said.
“If the buy-side commitment to derivatives is to be maintained in the face of increased cost and complexity, something’s got to give,” the executives wrote. “In this new environment of onerous reporting and clearing requirements, the buy-side must improve their operating efficiency.”
About 60 percent of the entire OTC derivatives market will be eligible to be processed by clearinghouses, the report said. That’s three times the amount predicted in a May report by the Office of the Comptroller of the Currency that assumed 20 percent of OTC derivatives in the U.S. can be cleared.
“We estimate 85 percent of credit-related OTC derivatives will be centrally cleared,” the executives wrote. They expect virtually all indexes of credit swaps and most swaps on individual companies that make up those gauges to be cleared.
Clearinghouses become the buyer to every seller and seller to every buyer, acting as a form of “super trading partner.” They require initial margin to accept a trade and monitor market prices several times daily to ensure losing investments don’t accrue. The trade-processing services can move positions from one bank to another as well, easing a situation such as when Lehman Brothers Holdings Inc. failed and its trading partners’ collateral was trapped by bankruptcy proceedings.
Clearinghouses also allow regulators access to traders’ portfolios and prices.
Swaps entered into between a bank and a customer generally had looser margin requirements than what will be mandated by clearinghouses, the Citigroup report said. The allowed use of non-cash margin such as mortgage-backed securities may make collateral management easier for investors and reduce systemic risk, the report said. That’s because if only cash were allowed, money managers may be forced to sell securities in stressful conditions to meet margin calls, “which in turn extends the market decline, creating a snowball effect,” the report said.
Investors also need to plan for managing collateral in the coming regulatory framework, the Citigroup executives said.
“If both the number of trades with margin requirements and the required margin amounts also rise, then a collateral shortage is quite possible, meaning market participants won’t have enough cash or eligible securities on hand to meet their requirements,” Sleightholme and Singh wrote.
--Editors: Pierre Paulden, Richard Bedard
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