By Rob Gray, Head of Sales EMEA differentia, Dion Global Solutions
The G20 has called for all standardised OTC derivatives to be centrally cleared by the end of 2012 with the intention to de-risk the markets. Sensibly, the regulators have put in place a staggered implementation requirement such that banks and brokers can deploy the necessary technology and processes for centrally clearing relatively straightforward derivative instruments before moving on to more complex asset classes.

Despite the bilateral nature of the OTC derivatives market, certain derivatives such as vanilla interest rate swaps options and credit indices are already cleared through Central Counterparties (CCPs). However, second, third and fourth tier derivatives provide more challenges.

In the example of FX options and especially exotic option contracts, the bespoke nature of each contract and the unique obligations they are designed to fulfill creates specific challenges, especially when it comes to pricing and valuation.

FX options involve a greater number of variables than more vanilla derivative instruments. Interest rates and timelines create considerable disparity between academics and quants about how contracts should be priced, and then actively risk managed and hedged across the lifetime of the option. The effect of this is that the trading of bespoke contracts of the FX option world is comparatively less transparent. This is in contrast to a price-driven market where, for example, trading indices on LIFFE mirrors the buying and selling of the cash market on LSE (as intended by the regulators).

Nonetheless, there are lessons to be learned from progress made to date – primarily that getting the right technological infrastructure in place is going to be critical, not just for individual participants but for the market as a whole.

Not only will banks need the models that can price and value exotic instruments in response to requests for quotes, but their corporate and other buy-side clients will almost certainly need some means of simultaneously comparing quotes from several sources and then initiating the trade with their preferred partner. Clearly understood models and independent data feeds will be essential.

Both parties will also need the means for selecting and initiating a trade with their preferred partner and then sending it to a CCP for clearing. The clearing house itself will need the tools to value a bank’s whole derivative portfolio in order to price the margin call needed at the end of each day. This process is rendered more complex by considerations of data privacy and client confidentiality, which preclude trade capture and counterparty data being sent to external servers.

Putting this infrastructure and expertise in place is a lengthy process that should not be underestimated. But before market participants can move forward and make the necessary investments with confidence, the central clearing houses will need to clarify which of the various pricing models they intend to apply to any given product for margin calculation. This is not to say that individual banks will not be able to make their own choice regarding which model to use when sending out quotes or pricing, or for calculating their own P & L. Quite the reverse. But what is essential is that each party at each stage understands which model is being applied. This transparency is essential if all players are to understand whether the value of a margin call and variation margin is based on for example, Monte Carlo or Black & Scholes methodologies, and whether they are able to calculate their own exposure and risk position.

For this to happen, the heads of FX trading at banks, clearing houses, regulators and technology providers will need to engage with each other to create a workable template that all parties can adhere to. So far this has not happened and with the next set of deadlines clearly visible on the horizon,the industry must work together in search of practical and viable solutions. Collaboration is now a matter of urgency.