hands on a steering wheel

OTC Derivatives Reform

Putting asset owners and sovereign wealth funds in the driver’s seat

November 2016

BNY Mellon experts and the University of Cambridge Judge Business School did a deep dive on over-the-counter (OTC) reforms and their impact on Sovereign Wealth Funds (SWFs). We begin a three-part series with an introduction of current investment practices of SWFs, concentrating on OTC derivatives and other key aspects of portfolio management.

Introduction

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:

  1. Contagion risk mitigation through mandatory central clearing and exchange based trading of standardised OTC derivatives as well as further risk mitigating actions including trade matching and Trade Repository reporting;
  2. Counterparty risk mitigation through stricter collateral requirements;
  3. More robust counterparty credit risk measurement via banking capital regulations; and
  4. Increased transparency.

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 programmes, 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 research project 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.

Asset Owners: New Perspectives and Priorities

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:

  • Investment Strategies
  • Risk Management and Investment Operations
  • Types of Derivatives Used and Clearing Practices
  • Evolving Operating Environment for SWFs and other Asset Owners


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