It's been fascinating the watch the rise of the new OTC derivatives market, one created from that classic OTC hodge-podge of big powerful dealers, phone-to-phone communication and lots of manual processes. Like them or not, Dodd-Frank's OTC derivatives aspects seem poised to pay off for Wall Street's big dealers and their top customers-if the market comes together as planned. 

A new report from Citigroup has concluded that two big markets--for interest-rate and credit-default swaps--will expand thanks in part to the new market infrastructure growing  more than 10 percent to $435 trillion by 2013. The assumption here is that the added price transparency and reduced counterparty risk that central clearinghouses offer would goose volumes as people will be more inclined to trade. We might see similar notional increases in other OTC markets. So the net effect could be quite dramatic. About 60 percent of the OTC derivatives market will be eligible to be covered by clearinghouses, the Citigroup report said. As noted by Bloomberg, that's three times the amount predicted in a May report by the OCC. 

But the forecasts for this sort of growth also depend on the buy-side's ability to truly boost their activity, which will not necessarily be easy or cheap. The fact is that many will be asked to post more in collateral to trade. 

"Users of these derivatives will need to post so-called initial margin, which can be liquid securities such as cash or government bonds, to send their trades to these central counterparties (CCPs)," according to the Financial Times. "They will also need to provide 'variation margin', depending on swings in the trades' value, and this can only be done in cash. The problem, according to clearing members, is that many derivatives users, such as pension funds or mutual funds, will not have enough eligible collateral to satisfy the requirements. Morgan Stanley and Oliver Wyman estimate in a report that more than $2,000 billion of additional collateral will be needed for over-the-counter (OTC) derivatives trades headed for central clearing in the coming years. A paper from the Bank for International Settlements has said variation margin may be more of an issue." 

So this has the buy-side talking about a whole new class of service, so-called collateral transformation services. This would involve a kind of alchemy by prime brokers, custodians, perhaps SEF, and clearinghouse members, to somehow turn "less liquid assets such as corporate bonds into CCP-eligible securities like cash or government debt through stock lending or the vast repurchase, or repo, market." A client with a portfolio of bonds for example could execute a repo on them to turn them into something that can be used as collateral. 

Morgan Stanley among others has predicted that this will drive revenue growth in capital markets over the next few years. Which is great news for the sell-side anyway.  

Of course, the market still awaits the final rules from the CFTC and the SEC. While there's a lot of upside here that wasn't necessarily seen before, it will ultimately be up to buy-side to figure it all out. They would no doubt like to available themselves of these markets, but it cannot ignore the added costs. Hopefully, this will turn out win-win. - Jim