Policy makers and regulators identified the opaque and interconnected nature of the OTC derivatives market as a major source of systemic risk and a significant contributor to risk contagion in the financial crisis of 2007-2009. To reduce the risks or impact of a repeat, a series of regulatory reform measures were developed, including:
These changes have had a profound impact on many market participants, both on the buy- and sell-side of the OTC derivatives markets. But the financial crisis and its aftermath uncovered other systemic weaknesses, many of which have been tackled by far-reaching reform programs, which have often had unforeseen consequences, in part because of the sheer number of the regulatory changes set in motion.
Not all of these reforms impact sovereign wealth funds (SWFs) and other asset owners directly. In fact, SWFs have been granted exemption from new OTC derivatives reforms, especially in Europe. Despite this, asset owners should be under no illusions about the extent of the changes wrought by the post-crisis reforms. The appetite and capabilities of service providers, the market’s perception of the value of different collateral assets, and the opportunities for asset owners to enhance their investment returns have all changed. As such, nothing less than a fundamental review of investment operations and strategy will equip SWFs and other asset owners for success in the evolving post-crisis landscape.
This thought leadership focuses on potential impacts for SWFs arising from the reforms to the OTC derivatives markets as well as other related post-crisis regulatory changes. Section 2 introduces the current investment practices of SWFs, concentrating on OTC derivatives but also outlines other key aspects of portfolio management. Then, Section 3 reviews the key reforms to the OTC derivatives market – namely mandatory central clearing, margin requirements, and banking capital requirements – as well as other reforms that are having a significant impact on SWFs and their counterparts. Section 4 lays out a cost-benefit analysis of SWFs’ options for OTC derivative clearing, touching also on broader strategic counterparty implications, while Section 5 addresses broader challenges and opportunities for SWFs and asset managers in light of current and expected market developments.
Although this report focuses on SWFs, the findings are also relevant to other large asset owners, in terms of their existing investment strategies and operations, and capacity to adjust to the challenges and opportunities presented by post-crisis reforms, such as those to the OTC derivatives markets. In this section, we look at existing investment practices and processes, including the use and clearing of derivatives, and the reasons why established approaches to investment may need to change.
Additional topics covered in this section include:
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