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The Global Risk Transfer Market:

Developments in OTC and Exchange

Traded Derivatives
A TABB Group Study

E. Paul Rowady, Jr.

Senior Analyst

V08:030 | November 2010 | www.tabbgroup.com

TABB Group Credit Default Swaps: Industry Projections | March 2009 1
Table of Contents

▲ Executive Summary.…………………………………………3
▲ Market Sizing….…………………………………………….. 9
▲ Trading Cost Analysis………………………………………24
▲ Collateral…………………………………………………..24
Collateral 24
▲ Clearing and Exchange Fees…………………………..31
▲ Bid-Ask Spreads………….………………………………38
▲ Conclusions……………….………………………………40
Conclusions 40
▲ Regulatory Update and Survey Results .. ………………46
▲ Appendices………………………………………………….58
▲ InterestRate Derivatives……………………...………...59
▲ Credit Default Swaps…………………………………….66
▲ Other Major
j Asset Classes……………………………...74

TABB Group The Global Risk Transfer Market | Nov 2010 2

Executive Summary:
Introducing the Global Risk Transfer Market
The Global Risk Transfer Market - GRTM Overview
Notional Values Outstanding – 2010e  OTC and exchange-traded derivatives markets are
two interdependent components of a single global
11% risk transfer mechanism serving all users, all needs.

 Mainstream and even insider views of OTC

derivatives markets remain uninformed. Using
89% notional values outstanding showcases size
differential – but distorts the risk differential - of
OTCDs relative to other liquid markets. When added
together, OTCDs represented 89% of notional values
outstanding at the end of 2009.

 Notional turnover is an additional metric that offers

Total Notional Turnover – 2010e new perspective on levels of trade activity and
showcases exchange-traded derivatives market as
large, if not larger, than OTCDs. TABB Group
estimates that ETDs will represent 55% of total
combined notional turnover for 2010.
55%  Both OTCD and ETD components of the GRTM offer
wholesale risk transfer; this is where they are
competitive. The difference is that OTCDs provides
bespoke risk transfer products and ETDs offer only
highly standardized products. The ETD market also
includes a subset of products that are useful to
OTC Derivatives (OTCDs) smaller institutions and individuals.
Exchange-Traded Derivatives (ETDs)
Source: BIS, WFE, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 3
Executive Summary:
Growth in OTCD and ETD Markets is Highly Correlated
700 684 100
Comparing Notional Values 625
(1998-2010e) 90
500 70

US$ Trillions

US$ Trillions



Tracking the siblings
200 30
 A visual and quantitative correlation of
growth confirms that OTCDs and ETDs
are two sides of the same coin. 20
100  Both components of the Global Risk
Transfer Market are simultaneously 10
complementary and competitive.
- -
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010e

OTCD (Left-hand scale) ETD (Right-hand scale)

Source: BIS, WFE, TABB Group

TABB Group The Global Risk Transfer Market | Nov 2010 4
Executive Summary:
Market Sizing by Notional Turnover
ETD 2,284 New Market Sizing Metrics
 TABB Group estimates that total combined notional
turnover in OTCD and ETD markets for 2010 is $3.7
quadrillion; ETD is often the larger
q g of the two on this
US$ Trillion

38 score.
 Interest rate products dominate both OTCD
25 and ETD markets, together representing 75%
of 2009 notional outstanding; short term
24 23 products ((<1 yyr)) dominate within ETD rates at
95% of notional open interest; OTCD rates
are 40% of notional values outstanding.
 OTCD equity exposures represent 49% of
1998 2000 2002 2004 2006 2008 2010e total global notional equity exposures.
 Notional turnover in ETD equity and interest rate
OTCD asset classes account for ETD’s notional turnover
size advantage vs. OTCDs. Unlike OTCDs,
Notional Values Outstanding 1,840
1,690 however, high levels of turnover in ETD are caused
Notional Turnover
by both structural and strategic activity:

Turnover Frequency
US$ Trillio

 St i
Strips: tto formulate
f l t longer
l term
t exposures
4.2 from short term instruments
3.4 3.1  Rolls: to move from front expiring months to
3.0 2.7
future months
 TABB Group p estimates the p
p of structural
trading in ETDs is no more than 5% of volume; high
turnover strategies account for 40% and are
1998 2000 2002 2004 2006 2008 2010e growing quickly.
Source: BIS, WFE, TABB Group Dashed points are interpolated estimates
TABB Group The Global Risk Transfer Market | Nov 2010 5
Executive Summary:
Collateral Leading Concerns
Percentage of Collateralized 75% Collateral Costs Increasing
70% OTC Trade Exposures ▲Increasing collateral costs remains remain the theleading
among amongparticipants,
OTCD participants,despite collateralized
despite OTC
60% collateralized
trades increasing
OTC trades
g 2.4x increasing
to nearly y 70% g 2.4x
and the
to nearly
of collateral
and theagreements
number of collateral
increasing agreements
3.1x to 172,000
50% increasing
since 2003.3.1x to 172,000 since 2003.
49% ▲The level of collateral for OTCD trades is still widely
▲The level of collateral for OTCD trades is still widely
40% believed
believed to to be
be too
too low.
▲Based on comparisons with ETD markets, gross
30% ▲Based
credit on comparisons
dit exposure (GCE) iin with
k t and gross
d currentt
credit exposure (GCE) in OTCD
data from CCPs for OTC credit derivatives, TABB markets, and current
20% data
Group from CCPs for
estimates thatOTC credit derivatives,
the additional collateralTABB
in OTCD markets is about $2 trillion, globally. required
estimates that the additional collateral
DueOTCDto end markets could be about
user exemption $2 trillion,
contemplated in globally.
29% 52% 55% 63% 59% 65% 66% 69%
0% ▲Due to the end user exemption contemplatedthis
regulatory reforms and several other factors
factors, in level
of collateral
current impactreforms
regulatory may never and be actualized.
other factors, this level
2003 2004 2005 2006 2007 2008 2009 2010e
▲TABB Group estimates that the
of collateral impact may never be actualized. near term collateral
OTCD FX Metals
Energy Equity Interest Rates impact of moving additional standardized OTCD
▲TABB Group estimates that the near term collateral
interest rate and credit exposures to CCPs is
impact of moving
approximately $240 additional
billion. standardized OTCD
Collateral Agreements i t
interest t rate
t and d credit
dit exposures tto CCPs CCP iis
150 ▲The increasing and pervasive use of collateral in
approximately $240 billion.

OTCD markets through CCPs – and the opportunity

100 costsincreased
▲The it representsuse -ofhas the potential
collateral in OTCD to overshadow
172 189
149 151 other cost
through efficiencies.
CCPs – and the opportunity costs it
133 Basel III is a- has
▲represents forcethewhich is likely to create incentives
50 110 potential to overshadow other
55 71 to mo
t tiel more
potential OTCD
ffi i risks
costt efficiencies.
i to CCPs
- ▲Basel III is a force which is likely to create incentives
2003 2004 2005 2006 2007 2008 2009 2010e to move more OTCD exposures to CCPs.
Source: ISDA
TABB Group The Global Risk Transfer Market | Nov 2010 6
Executive Summary:
Bid-Ask Spread Improvement Expected from SEFs
Bid-Ask Spreads will fall, selectively Bid-Ask Spread Comparison
▲ Potential bid-ask spread (BAS) improvement exceeds 96% 50.0 Same Day, Same Time (for ETD)
▲ Like transaction fees, BASs are blind to labels like OTCD
and ETD; BASs respond to liquidity independent of
execution method.
▲ OTCD products that meet broad needs are destined for
lower costs in paradigm transformation.
Bid-Ask Spread Comparison
US$ Value of BAS for “First
First Million”
Million 50

sis Points
30y IR Swap Future

og Scale
OTC CDS Single (HY)
1,600 OTC 10y IR
OTC CDS Single (IG)

$1 000
$1,000 5y IR Swap Future
OTC CDS Index (HY)
og Scale

343 400 30y T-Bond Future 0.5

328 Potential
200 S&P 500 Index Future improvement
OTC 10y IR Swap 96% 30y IR Swap Future

$100 OTC CDS Single (HY)

OTC CDS Index (IG)
70 OTC CDS Single (IG)
Eurodollar Future 5y IR Swap Future
** OTC pricing estimates reflect Eurodollar OTC CDS Index (HY)
Future S&P 500 Index Future
combination of both dealer - to -
dealer (D2D) and customer - to - 30y T-Bond
T Bond Future
13 0.1
$10 dealer (C2D) trades. OTC 10y IR Swap
OTC CDS Index (IG)
Sep 2010 Eurodollar Future
Source: CME, TABB Group HY = High Yield, IG = Investment Grade
TABB Group The Global Risk Transfer Market | Nov 2010 7
Executive Summary:
Reform Impacts and Stakeholder Sentiment

View on new margin

D clearable?
on spreads?

on liquidity?
Reform Impacts

trading for OTCD?

ETD ussage/focus

Firm’s view on e-
by/of yyour firm?

by/of yyour firm?

View on Trade

 OTCD reform’s primary

pact on
focus continues to be:
reducing systemic risk

Impact o

Impact o

and increasing overall
market transparency for
both price and
Top-Tier Dealers      positions.

 There is consensus on
“Emerging” Dealers     tactics – centralized
clearing for
Traditional Buy-Side      standardized
instruments, tighter
Hedge Funds     requirements on
collateral, and cleared
Corporate End Users     contracts on a
registered execution
Exchanges / Clearinghouses     venue – but
implementation will be
Inter-dealer Brokers / OTC
Execution Venues    slow for end users,
coming online in 2011
through 2013.
Data Providers / Aggregators   
Increase Decrease Same Positive  Negative  Indifferent
TABB Group The Global Risk Transfer Market | Nov 2010 8
Market Sizing

TABB Group The Global Risk Transfer Market | Nov 2010 9

Derivatives markets – both OTC and exchange-traded - are too complex to be
explained by simple comparisons using notional values outstanding over
limited time frames; Notional values of derivatives can overstate systemic risks
Additional details are essential to
Mainstream View of Global Financial Markets understanding these markets
700  The financial press and mainstream media are
625 known to portray OTC derivatives (OTCD) markets
596 as the largest in the world using notional values
600 outstanding over a limited time frame.
 This view is overly simplistic and a misleading
500 depiction of both OTCD and exchange-traded
US$ Trillions

derivatives (ETD) markets.

400  Notional – or face – value of the underlying
transactions only tell part of the story and imply
excessive levels of leverage and risk in OTCD
300 markets.
 OTCDs and ETDs are a subset of a broader
200 mechanism to transfer risk among a diverse
spectrum of participants and for a wide array of
79 79 83 92 91 80
100 61 73 B other
By th measures – suchh as notional
ti l tturnover – the
58 48 44

33 ETD market is occasionally the larger sibling of the
2007 2008 2009 2010e  Details of each asset class coupled with additional
OTC Derivatives ((OTCDs)) - Notional Values Outstanding
g a et ssizing
market g metrics
et cs – pa
t cu a y notional
ot o a tu
o e
Debt - Market Value – complement open interest or notional values
Exchange-Traded Derivatives (ETDs) - Notional Open Interest outstanding and foster much greater understanding
Equity - Market Capitalization of the underlying products and market participants.
Source: BIS, WFE, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 10
Greater understanding of OTCD starts with direct comparison with ETD, a
wider range of time, and additional market sizing metrics; ETD and OTCD are
both complementary and competitive
700 Peak = 684 20 OTCD and ETD: two components of a
single risk transfer market
Comparing Notional Values 625
(1998-2010e) 18  ETD provides the optimal market comparison
600 ((instead of the cash markets)) due to their similar
16 products, risk profiles, and customers. In fact,
OTCDs and ETDs are complementary and
symbiotic for product development; one is a
500 14 primary source of innovation for the other.
US$ Trilliions

 A broader time horizon supports

pp interpretation
p of
12 the relationship between these markets where
notional values have a correlation exceeding
9.6 90% since 1998.
 High correlation indicates that both markets
300 have the same or similar drivers. However, in
6.7 December 2007 and leading up to the credit
7.8 crisis of 2008, the correlation shifts – with the
200 6 OTCD:ETD ratio peaks at 9.6 - due to increased
activity in Credit and structured products, like
4.9 4.2 4 CDOs.
Peak = 95
100 80  Although OTCD and ETD represent significant
2 differences in the needs that they serve, both
compete to serve wholesale risk transfer needs.
- -  As the OTCD markets adopts more of the
operational aspects of the ETD markets – both
voluntarily and by mandate - they will be
viewed more as two components of a single
Source: BIS, WFE, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 11
A visual and quantitative correlation of growth confirms that OTCD and ETD
are two sides of the same coin

700 684 100

Comparing Notional Values 625
(1998-2010e) 90
500 70

US$ Trillions

US$ Trillions



Tracking the siblings
200 30
 Standard deviation of OTCD growth is 9%
as compared to over 22% for ETD (or 2.5 20
times that of OTCD)
OTCD), which is easily visible
100 from the chart. Before the credit crisis,
OTCD growth was extremely consistent, 10
with a standard deviation of 6%.
- -
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010e

OTCD (Left-hand scale) ETD (Right-hand scale)

Source: BIS, WFE, TABB Group

TABB Group The Global Risk Transfer Market | Nov 2010 12
Basic asset class breakdowns demonstrate that interest rate products
dominate both sides of the global risk transfer market

Interest rate investing and hedging

represent the largest global liquid
Notional Values
market segment 2009
 Credit instruments are currently almost
non-existent in the ETD market, although Equity-Linked
this may change with the launch of CDS 1%
options on the CBOE. Commodity
Credit <1%
 ETD equity-linked notional open interest is FX 5%
several times the proportion of OTCD Other **
equities because they generally serve
different purposes: OTCD - hedging for
physical asset holders; ETD - trading and
investment for asset managers and
 FX appears to be a smaller part of ETD
since it is heavily weighted in very short
term trades.
Equity- Commodity Other *
1% 1% FX

ETD ($73 trillion) OTCD ($615 trillion)

Source: BIS, WFE, TABB Group * ETF options ** Unallocated

TABB Group The Global Risk Transfer Market | Nov 2010 13
OTCD product mix has become more concentrated in swaps due to growth in
interest rate products; ETD options have overtaken futures due to adoption of
equity derivatives within mainstream strategies
700 OTCD Notional Outstanding 90 ETD Notional Open Interest Stable but evolving product
By Product 80 By Product mix
70  With few exceptions, the overall
US$ Trillions

500 product mix has evolved and

400 changed slowly. For instance,
jump in ET options in 2001 signals
300 40 launch of ISE.
30  OTCD – or wholesale - markets
200 OTCD markets
20 
serve “bulk” andserve both hedging
p bulkg and
100 precision
i i h
needs. hedging
d i needs. d
- 
 Banks,
Banks, financial
financial firms
firms and
and large
1999 2001 2003 2005 2007 2009 corporations use the
corporations use OTCDs to OTCD
1999 2001 2003 2005 2007 2009
manage mainly
manage interest
and currency
100% 100% rate and
risks thatcurrency risks
are too large g or that are
impractically large
to manage using ETDs. or require
80% 80% unique precision to manage in ETD
 markets.
Firms in the food, energy, and
60% 60%  manufacturing
Firms in the food, industries
energy,use and
OTCDs to manage
manufacturing mainly physical
use OTCD
k t dit
markets to risks
i k for
t manage f physical
h ii i l that
th t
40% 40%
cannot be achieved
commodity in ETDs. that
risks for precision
cannot be achieved in ETD.
20% 20%  ETDs shows greater shifts
 ETD shows greater shifts
principally due to its diversity. For
principally due to its diversity. For
0% 0% instance,, growing
g g adoption
p of
instance gro
instance, growing
ing adoption of
1999 2001 2003 2005 2007 2009 1999 2001 2003 2005 2007 2009 options in mainstream strategies is
options in mainstream strategies is
fueled by individuals and pros
Swaps Options Forwards/FRAs Unallocated Futures Options fueled by individuals and pros
Source: BIS, WFE, TABB Group alike.
TABB Group The Global Risk Transfer Market | Nov 2010 14
Since OTCD activity were first published in 1998, total notional turnover in
ETD has consistently been greater than OTCD; Notional turnover in these
markets has been measured in quadrillions since 2004
Notional turnover values shed a new -perspective
and bright -on
on global
 Comparisons of OTCD markets with other markets are more illustrative when notional turnover is included. Thanks to trade
repositories, this level of detail is now possible with greater accuracy, detail and regularity.
 Notional turnover normalizes the activity between OTCD and ETD markets, which eliminates the need for comparisons based
on the variety of contract sizes in ETD and the lack of contract sizes in OTCD.
 Levels of notional turnover provide numerous additional insights into the nature of these markets including: underlying
strategies; composition of market demographics; product maturity composition; and level of operational integrity.
 The calculation of turnover frequency (TOF) - the ratio of turnover values to notional values outstanding - is the best indication
off short
h t term
t trading
t di levels,
l l llonger tterm iinvestment
t t and
d overallll h
d i Hi
h TOF often
ft iindicates
di t greatert liliquidity.
 The main drawback in using ETD notional turnover is due to the high levels of structural activity caused by “rolling” from month
to month and/or developing longer term exposures from “strips” of short term instruments. TABB Group estimates that up to 5%
of ETD turnover can be attributed to this type of structural activity.
OTCD ETD 2,284
Notional Values Outstanding
US$ Trillions

Notional Turnover 38
Turnover Frequency

4.2 28
3.4 3.1
625 24 23


1998 2000 2002 2004 2006 2008 2010e 1998 2000 2002 2004 2006 2008 2010e
Source: BIS, WFE, TABB Group Dashed points are interpolated estimates
TABB Group The Global Risk Transfer Market | Nov 2010 15
Turnover frequency (TOF) points to the structural makeup of a market as well
as the strategies participants implement within those markets

Annualized Turnover Frequency (TOF) Ranking

All Derivative Markets - 2009 100 Diversity, automation, liquidity
,  TOF can become skewed with a bias to
instruments with short term maturities.
80  Strips used to formulate longer
800 term exposures from short term
How will the TOF gap change?

60  Rolls used to move from front

US$ Trillio

expiring months to future months

 Limited participants and low process
automation limit turnover frequency, and
400 therefore, market liquidity.
 As large market segments like OTC
interest rate derivatives trade and clear
200 20 more like futures, the market will realize
significant cost savings and greater
0 -  The impact of doubling TOF for OTC
interest rate swaps – from roughly 1 to 2
- would yield an additional $350 trillion of
global annual trading activity.

Open Interest Turnover TOF

Source: BIS, WFE,TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 16
On global notional turnover, ETD futures and options dominate in 2 asset
classes and very strong in a third; Account for a slight majority overall for 2009
Relative Global Derivative Exposures
By Total Notional Turnover of Asset Class (2009) Sizing ETD and OTCD by asset class
100% 5% 5%  ETD notional turnover exceeds their
counterparts in equity-linked
OTCD equity-linked
and interest
and rate
80% 44% OTCDs;
interest rates;
very strong
very strong
in commodities.
in commodities.
68% 70%  Despite ETD dominance in equities, OTCD
100% notional outstanding is still substantial,
95% 95%
40% indicating
. This
use of
is aOTCD
by large
by large players.
32% 30%  Taking outstanding values and notional
turnover together, OTCD and ETD can be
characterized as one interconnected and
Equity Linked Rates Commodity Other * FX Credit
interdependent market serving different
needs.; strengthening
needs; gg ggthis
Strengthening thisinterdependency
pp yy
By Notional Outstanding of Asset Class (2009) benefits both components of the global
sides of this amazing risk
100% 1% 1% transfer market (GRTM).
12% 20%
80% Total GRTM Notional Turnover
51% 2009
99% 99% 100%
40% 88% 80%
20% 49% 50.6% 49.4%

Equity- Rates Commodity Other * FX Credit
* Other includes ETF Options (ETD)
OTCD ETD and unallocated exposures (OTCD)
Source: BIS, WFE, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 17
OTCD market exposures originate primarily in Europe while ETD shows
waning dominance in North America; Regional dynamics changing slowly
which will accelerate with growth in APAC markets
OTCD – Notional Turnover Achieving
Achieving regional
regional balance
 Europe remains the epicenter of OTCD
US$ Trilllions

16% dealing due to London’s dominance in
interest rate dealing
dealing. However
However, it is
slowly ceding its dominance as US and
1,000 64% APAC activity grows.
 The concentration is less pronounced
500 64% when viewed by underlying currency.
21% 23% Single-currency OTC interest rate
22% derivatives and Euro-denominated
2004 2005 2006 2007 2008 2009 2010e trades edge out US-dollar-
denominated trades, 39% versus 34%
Dashed points are interpolated estimates in 2009.

ETD – Notional Turnover  A surge in ETD volumes for the first

2,500 half of 2010 – up over 30% yoy – are a

7% strong indication that reforms in the

2,000 12% OTCD markets is causing participants
8% 35%
8% 39% 10% to shift some of their risk transfer
1 500

8% 35% 40% activities to ETD.

34% 40%
1,000 37%
 However, due to the benefits of
500 57% 54% precision hedging and balance sheet
58% 50% 48%
relief afforded by OTCD derivatives
- (via FASB 133)
133), there are limits to the
2004 2005 2006 2007 2008 2009 2010e substitutability of ETD and OTCD
Americas EMEA APAC trades. ETDs do not provide balance
Source: BIS, WFE, ISDA, FIA, TABB Group
sheet relief.
TABB Group The Global Risk Transfer Market | Nov 2010 18
The distribution of collateralized counterparties by country of incorporation
paints a different picture of regional OTCD exposures; Suggests US and EU
banks, asset mgrs. and corps. are heavily engaged in hedging foreign risks
Percentage of Total Global OTCD Exposures
By Country of Incorporation
US and Canada

24% The West dominates OTCD

Western Europe
 How can the value of turnover be higher in
EMEA, while the number of collateralized
20% counterparties in the US and Canada be
Caribbean higher at the same time?

 The chart suggests that US-based entities -

4% mainly corporations and banks – are
Japan hedging interest rate and currency risk
incurred through foreign trade.

4%  Growth in Caribbean counterparties is

APAC (ex-Japan) ** indicative of the growth of OTCD trading by
hedge funds as well as corporations in the
energy sector often registered offshore.
Other *  Low utilization of OTCD in APAC is
indicative of how important floating rate
currencies are (e.g. – China) and more
0% 10% 20% 30% 40%
importantly, 50%this region
the potential 60%
represents for future OTCD growth.
2009 2005 2001

Source: ISDA * Includes Latin America, Eastern Europe, and Africa; ** includes Hong Kong, Singapore and Australia
TABB Group The Global Risk Transfer Market | Nov 2010 19
Dramatic change in OTCD demographics is direct link to search for multi-asset
alpha by hedge funds and prop desks; ETD influenced primarily by high
frequency trading strategies
Corporate Use of OTCD Futures End User Breakdown
2009 % of Contract Volume OTCD demographics
All 94% 16% 17% 18% 19% CDS and other complex structured
20% 
Rates 88% products, like CDOs, had a major
28% 26%
impactt on OTCD d demographics
hi iin
FX 83% 39% 35% 25%
the past 5 years.
Commodity 49%  Alternative asset managers and
Equity 29% proprietary trading desks of large
54% 55% 55% financial companies flocked to
Credit 20% 45% 48% th
these new products.
d t

OTCD End User Breakdown

 Since operational integrity usually
% of Outstanding Notional 51% lags the relentless search for alpha,
50% 2006 2007 2008 2009 2010e risk management functionality was
Options End User Breakdown lacking in this growth.
40% % off Contract
C t t Volume
V l

19% 15% 15% 15%

30% 29% 30% ETD demographics
 High frequency trading (HFT) has
20% 34% 35% 40% become common in futures. HFT
25% firms typically become exchange
12% members to lower trading costs.
 Bigger retail component in ETD
45% 47% 50% 45% options.
0% 42%
2006 2007 2008 2009  Overall, listed derivatives adoption
Broker-Dealers Other Financial is increasing for both traditional and
Customers Unallocated
2006 2007 2008 2009 2010e alternative investment strategies.
Source: BIS, CME, Tabb Group
Broker / Dealers Other Financial Customers
TABB Group The Global Risk Transfer Market | Nov 2010 20
Use of OTC derivatives is common but varies widely among Global Fortune
500 corporations; Healthcare and Technology sectors are most correlated to
Financial sector usage, Basic Materials and Utilities least
Sector Usage of OTC Derivatives by Global Fortune 500 Corporate OTCD Usage
(2009)  On a weighted average basis, 94% of
Global Fortune 500 companies use
All OTC derivatives, where the largest
Sector Name Rates FX Credit Equity Commodity
OTCD sector is Financial with 123
companies in 2009.
Basic Materials (86) 97% 70% 85% 0% 6% 79%
 The sample of the world’s largest
Consumer Goods (88) 91% 81% 84% 1% 9% 39%
companies span 32 countries
Healthcare (25) 92% 80% 72% 4% 20% 8%
 While the Financials sector does not
Industrial Goods (49) 92% 86% 86% 2% 20% 37% always skew the figures, it does have
Services (40) 88% 75% 85% 3% 13% 35% a dramatic impact on the usage
figures for Credit and Equities.
Technology (65) 95% 86% 92% 6% 15% 15% Clearly, Financials firms represent a
vast majority of the usage of OTC
Utilities (24) 92% 92% 88% 0% 8% 83%
credit derivatives and a slight majority
Financial (123) 98% 94% 96% 76% 80% 63% of OTC equity derivatives.

 Healthcare and Technology

companies are most highly correlated
Weighted Average
93% 80% 85% 2% 12% 44% with Financial companies in their
(w/o Financials)
usage of OTCD (at .90 and .87,
respectively); Basic Material and
Weighted Average Utilities are least correlated (at .25
94% 80% 85% 20% 28% 48%
(w/ Financials) and .32,, respectively).
p y) This metric
indicates the potential degree to
which specific sectors could be
>75% < 25% impacted by pending reforms.
Source: ISDA, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 21
Overall, this is a tale of two equally large and interdependent components of a
single global risk transfer mechanism, each serving specific purposes for
specific end users
Exchange-Traded Derivatives OTC Derivatives
Limited Products Unlimited Products

Many Participants Few Participants

ETDs operate for the benefit of a broad, diverse OTCDs operate like a wholesale market for the
community of large and small participants largest firms w/ specific exposure requirements
 Every type of market player is represented here: From  An unlimited spectrum of products can be devised to
amateur to professional, from individual to institutional, and precisely address the needs of the world’s largest financial
from trader to hedger
hedger, the exchange
traded derivatives intermediaries and corporations.
markets serve almost all global risk transfer needs at a  The unlimited flexibility of OTCD is, therefore, the greatest
reasonable cost with speed, accuracy, and reliability. source of product innovation for ETD.
 Given its standards, fault tolerance and capacity, the ETD  As the past few years have demonstrated, diversification of
market is currently the best model we have for operational market demographics without congruent operational
integrity. integrity created unforeseen risks.
 In the current environment, ETDs represent an outlet for  Addressing operational integrity continues to represent
some risk transfer needs that were previously conducted in massive growth potential for these markets.
TABB Group The Global Risk Transfer Market | Nov 2010 22
The differences between OTCD and ETD are both complementary and
competitive, serving the broadest spectrum of end user needs

Attribute OTC Derivatives Exchange-Traded Derivatives

# Participants Limited (~30,000) Expansive (~5,000,000)
Inter-Dealer Brokers (5-20), Dealer Banks (50-
100), Other Banks (2,000 – 5,000), Other
Financial and Corporations, including securities All of the OTC types, plus traditional asset
End User Types
firms, insurance companies, asset managers, managers and individual investors (~5,000,000)
hedge funds, and proprietary trading firms

Swap (single and cross-currency), Forward Rate

Agreement (FRA), Swaption, Basis Swap, Cap, Vanilla options and futures (> 8,000 unique
Product Categories
Floor, Exotic Swap, Inflation Swap, Debt Option, contracts)
Exotic Option, Exotic Cross-Currency Swap

H d i primary,
i iinvestment
t t and
d ttrading
di IInvestment
t t and
d trading
t di primary,
i hedging
h d i
Strategy Types secondary; Limited annual turnover range: secondary; Broad annual turnover range:
1 –20x 1 – 100x
Outstanding Notional $625 trillion (2010e) $80 trillion (2010e)
Notional Turnover $
$1.7 quadrillion (2010e) $
$2.0 quadrillion (2010e)
Contract Open Interest NA 1.02 billion (2009)
Contract Volume NA 22.4 billion (2010e)
Annual Transactions / Trades ~16
000 000 (2010e) ~3
3 billion (2009)
Average Trade Size / Value NA / $105 million (2010e) 5.9 contracts / $103,000 (2009)
Regional Breakdown (2010e) N. America: 23%; APAC: 16%; EMEA: 61% N. America: 48%; APAC: 12%; EMEA: 40%
TABB Group The Global Risk Transfer Market | Nov 2010 23
Trading Cost Analysis:

TABB Group The Global Risk Transfer Market | Nov 2010 24

The main goals are clear: minimize systemic and counterparty risks and
promote price transparency; Accomplishing these goals will create new costs
and cause the cost mix to shift: collateral up, spreads and commissions down
Main Components of Trading Costs Anatomy of a Trade
Shifting Paradigm, Shifting Costs
 There are as many as 6 primary components to the “trading cost
stack” for ETD and the proposed OTCD multilateral paradigm.
The q
question is how these costs will shift as OTCDs adopt
operational components of the ETD market.
Margin and
Opportunity Margin and Collateral  TABB Group believes that moving from “bundled” to “unbundled”
Costs Collateral cost models does not bring into question the persistent need for
wholesale and bespoke functions within the global risk transfer
Bid Ask
Bid-Ask market. Overall, costs categories will shift, but aggregate
Spread transaction costs will decrease over the longer term.
Implicit Bid-Ask  Goal #1: Minimize systemic and counterparty risks
Costs Spread Clearing  Solutions: Central counterparty clearing (CCP) for standardized
Fees instruments, and margin requirements for all transactions (both
Costs standardized and exotic, cleared and bilateral).
 Cost Impacts:
 New margin levels and collateral requirements
Broker Fees
 New clearing fees
Fees *
 Admin/legal costs down; technology costs up
E li it Broker
B k --------------------------------------------------------------------------------------
Costs Fees  Goal #2: Price transparency
 Solutions: Increase multilateral price discovery through
Admin and exchange-like mechanisms, or swap execution facilities (SEFs).
Legal Fees Admin and  Cost Impacts:
Legal Fees  New exchange g fees
 Broker fees decrease (as volume increases)
Bilateral Multilateral  Bid-Ask spread compression (as diversity increases)
Paradigm Paradigm  Technology costs up due to multi-system connectivity
* Interdealer trades only
TABB Group The Global Risk Transfer Market | Nov 2010 25
Increasing collateral costs is the leading concern for OTCD participants,
despite collateralized OTC trades increasing 2.4x to nearly 70% and the # of
collateral agreements estimated to increase by 3.1x to 189k since 2003
Percentage of Collateralized OTC Trade New Collateral Rules likely
▲Just because the use of collateral is increasing doesn’t
70% necessarily mean that trades are margined at proper levels.
▲Although an average of 69% of OTCD trades are
collateralized, specific and standard levels are currently
60% unknown. They will ultimately vary widely by asset class,
product, end-user type.
▲Rates exposures are most highly collateralized at 75%;
50% Metals are lowest at 49%. Hedge g funds p
post the
49% highest margin levels, often exceeding 100% of net
exposures – followed by banks and BDs; non-financial
40% corporations, sovereigns and supra-national firms tend
to have the lowest levels.
▲The cost of collateral is a capital efficiency issue; it should be
categorized as an opportunity cost, not a sunk cost.
▲With increasing and pervasive use of collateral in OTCD

20% markets through CCPs, collateral cost has the potential to

outweigh all other cost efficiencies over the long term.

Collateral Agreements

29% 52% 55% 63% 59% 65% 66% 69%

0% 100 189
2003 2004 2005 2006 2007 2008 2009 2010e 151 172
133 149
50 110
OTCD FX Metals 55 71
Energy Equity Interest Rates
Credit -
2003 2004 2005 2006 2007 2008 2009 2010e
Source: ISDA, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 26
Gross credit exposure (GCE), the total liabilities to counterparties, is a useful
benchmark for the total OTCD margin requirement; GCE is currently >$3.5
trillion for 2009
Growth of Collateral in the OTCD Market The GCE Benchmark
50% ▲ Gross credit exposure (GCE) for OTCD represents
45% “represents
“the current the valuecurrent
of contracts
value ofthat contracts
have a that
5,000 45% ap
positive value
taking gafter
taking gofaccount
g y of
legally enforceable
enforceable bilateralbilateral
netting netting
agreements. agreements;
In otherin

al Commitment to GCE
40% other words,
words, it measures
it measures
credit credit
between counterparties”,
counterparties”, accordingaccording
to ISDA. to ISDA.
4,000 ▲ Using GCE as a benchmark, the OTCD collateral
35% ▲ Using GCE as a benchmark, the OTCD collateral
3,520 requirement was over $3.5 trillion
forfor 2009.BasedBased

q is over $3.5 trillion 2009. on
US$ Billion

on th
the ISDA M
Margin i S
the 2010 ISDA Margin Survey, TABB Group 2010
2010, TABB G
estimates that that $1.6
$1.6 trillion
trillion of
of collateral
collateral -– 45% or 45%of of
3,000 GCE
GCE -- is is already
already committed
committed in in OTCD
OTCD markets
25% (82% of collateral is cash in major currencies with
of collateral is cash in major currencies with another
10-15% 10-15% of collateral
of collateral posted inposted in government
20% securities
iti ) )

% Collatera
2,000 ▲ A note on single-counting versus double- counting:
1,576 ▲A noteMargin
ISDA on single-counting
surveys do not versus
adjust double- counting:
for double-
ISDA Margin surveys do not
counting – i.e. both collateral delivered andadjust for double-
collateral –received
i.e. both–collateral
because delivered
its goal isand to measure
10% collateral
1,000 the usage g of collateral and not the valuetoofmeasure
received – because its goal is assets
the usage of collateral and not the value of assets
posted as collateral.
5% posted as collateral.
▲ However, for centrally cleared trades, both
▲ For centrally cleared must posttrades,collateral
however, as initial
both and
- 0% variation margin,
counterparties generally
must in an amount
post collateral estimated
as initial and
1999 2001 2003 2005 2007 2009 to cover amargin,
variation 5-day loss, with 90%
generally in anconfidence.
amount estimated
Gross Credit Exposure (GCE)
Therefore, TABB Group believes
to cover a 5-day loss, with 90% confidence. that using aTABB single
Collateral Commitment (Single Counted) counting
Group methodthat
believes for using
the ISDA a singlemargin estimates
counting method
% of GCE offers
for thetheISDA most accurate
margin reflection
estimates offersof the
wheremost the
Source: BIS, ISDA ,TABB Group value of collateral
accurate reflectionisoftoday.
the current value of collateral.
TABB Group The Global Risk Transfer Market | Nov 2010 27
ETD margin levels represent an alternate method to estimate the total
collateral benchmark for OTCDs; Margin levels vary widely by asset class, but
are based mostly on volatility
Interest Rate Futures Alternate OTCD collateral benchmark
5% Effective Margin and Average Volatility Samples 12
▲Outright margin levels for fornaked
“naked” positions

4% 10

maximum margin requirements. Spread Spreadpositions,

Initial Margin
g ((%)) 8 like option
p straddles, require
q margin
g levels that are

Average V
Effective M

Maintenance Margin (%) a fraction of outright margin levels, and often therefore,
Avg Volatility (2010 YTD) 6
2% minimum
often reflect margin
margin requirements
due to limiteddueandto
4 finite
and finite risks.
1% 2 ▲Key factors that influence outright margin levels
▲Key factors that influence outright margin levels
include volatility, duration, liquidity and complexity of
0% - include volatility,
volatility duration,
trade structures. duration liquidity and complexity of
trade structures.
▲Liquidity premiums can sometimes cause
margin requirements
▲Liquidity premiums can to sometimes
double. cause
▲Cross-margining, portfolio margining
margin requirements to double.and other
netting techniques, which will continue to become
Equity Index Futures ▲Cross-margining,
more common in both portfolio
and OTCD and other can
Effective Margin and Average Volatility Samples netting
result intechniques will continue
additional reductions in to become more
15% 25

e Volatility
requirements.in both ETD and OTCD markets, resulting
Effectivve Margin

13% 20 in additional reductions in margin requirements.

▲For instance, in 2009, OCC/CME cross-
10% margin participants realized an average daily
15 ▲In 2009
2009, OCC/CME cross cross-margin
margin participants
reduction in margin requirements of $1.6 $
10 realized an average daily reduction in margin
5% billion, or a 53 percent savings per
requirements of $1.6 billion, a 53 percent
3% 5 participant.
savings per participant.
0% - ▲Increasing adoption of CCPs also means greater
use of systematic,
▲Increasing adoptionSPAN-type
of CCPs also margining
meansfor OTCD
use (j t lik
off systematic, likeSPAN-type
i ETD).
ETD) For Fmargining
th trades
t for
f d OTCD
O that
remain bilateral, margin levels will continue
exposures (just like in ETD). For those trades that to be
set on abilateral,
remain proprietary basis.
margin levels will continue to be
Source: CME, Eurex, TABB Group set on a negotiated basis.
TABB Group The Global Risk Transfer Market | Nov 2010 28
TABB Group estimates total global ETD margin at nearly $450 billion in 2009,
representing 0.6% of notional open interest; Applying this benchmark to OTCD
yields a total collateral estimate of $3.8 trillion for the same period
ETD Margin Benchmark Calculating ETD margin
500 449 1.00%
benchmark for OTCD

400 ▲Based on total margin levels

0.61% 0.75%
reported to the CFTC and OCCOCC,

o of Margin to N
US$ Billio

300 and given the proportion of

0.50% exposures in the US relative to
200 the rest of the world, TABB Group
134 estimates that total global margin
78 0.25% posted for ETDs in 2009 was

nearly $450 billion, or 0.6% of
- 0.00% notional open interest. ($134b +
2005 2006 2007 2008 2009 $78b / 47% = $449b; $449b / $73t
ETD notional = 0.61%)
US Options Margin (OCC)
US Futures / Options on Futures Margin (CFTC) ▲ Applying this level as a
Global ETD Margin Estimate benchmark for OTCD collateral
Margin as % of Notional Outstanding
requirements yields an expected
level of nearly $3.8 trillion for
Applying ETD Margin Benchmark to OTCD 2009.
Percentage of Notional Values Outstanding 4,699 2.0%

Ratio of Margin to
3 776
US$ Billion

4,000 3 508
3,508 1 5%

3,000 2,014 1.0%
2,000 1,545
- 0.0%

2005 2006 2007 2008 2009
Collateral Requirement (ETD Benchmark)
ETD Margin Benchmark (%)
Source: CFTC, OCC, TABB Group

TABB Group The Global Risk Transfer Market | Nov 2010 29

If all OTCD were moved to CCPs today, GCE and ETD benchmarks show that
the additional collateral requirement could be as high as $1.9 – 2.2t; Near-term
impact is closer to $240b based on $42t of vanilla swaps at the top 14 dealers
5,000 Targeting OTCD 4,699 Calculating OTCD collateral
Collateral Requirements
▲Despite strong growth in the use of collateral agreements and
4,555 3,776
US$ Billiions

4,000 Comparison of the 3,508 proportion of collateralized transactions, TABB Group estimates
ETD and
d GCE Margin
M i that the total collateral commitment in OTCDs today is too lowlow.
Benchmarks 3,520 Applying the previously defined GCE and ETD benchmarks,
3,000 3,256 the additional collateral requirement could be as high as $1.9 -
$2.2 trillion based on a move of all OTCD exposures to CCPs
1,900 2,036 today (assuming total est. OTCD collateral for ‘09 was $1.6t).
h k ▲The current collateral levels at ICE Trust US and ICE Clear
ETD Benchmark Europe for credit derivatives further confirm the range of the
1,545 GCE and ETD benchmarks; the combined guaranty funds in
2005 2006 2007 2008 2009 the US and Europe yield a collateral benchmark of 0.5%.

OTCD Margin Requirement ▲The next tranche of OTCD exposures, which are among the
5,000 4,555 most likely to be migrated to CCPs,
CCPs are vanilla swaps at the top
Current versus
Additional Collateral 14 dealers currently not already cleared. According to the trade
4,000 3,520 repository for OTC IR derivatives, these swaps total $42 trillion,
$ Billions

3,256 as of October 1, 2010. Applying the GCE benchmark of 0.6%

3,000 yields an additional collateral requirement of $240 billion.
2 036
2,036 1,944
1,944 ▲The estimated total additional collateral requirement is not likely

1 900
1,900 2,193
2,000 to ever be levied. Factors that contribute to reductions in
1,235 1,368 collateral include: 1) Not all OTCD exposures will move to
1,000 1,979 CCPs, 2) high likelihood of end-user exemption, 3) extremely
1,063 short term exposures, like a majority of FX, will require little or
665 668
- no collateral, and 4) innovations in cross-margining.
cross margining.
2005 2006 2007 2008 2009
▲Factors that increase collateral requirements include:
Current Margin (Single Counted) increasing volatility, decreasing liquidity, increasing duration,
Additional Margin Requirement increasing complexity, and lack of netting efficiencies.
Source: BIS, ISDA ,TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 30
Trading Cost Analysis:
Clearing and Exchange Fees

TABB Group The Global Risk Transfer Market | Nov 2010 31

Continued increases in collateralized OTCD trades are influenced in large part
by growing adoption of CCPs, which also bring new clearing fees and service
opportunities; LCH SwapClear, ICE Clear and CME ClearPort lead the way
LCH Clearnet – SwapClear OTC IRS Clearing IR Swaps lead
Notional Amounts Cleared and Trade Registrations ▲ A majorityof dealer-to-dealer
240 228 80
(D2D) OTC interest rate swaps


220 60 are currently cleared by LCH

US$ Trillio

61 Clearnet’s SwapClear service,

200 40 including 20 currencies and
Overnight Indexed Swaps (OIS)
180 20
▲ Asof August 2010, SwapClear
160 - has cleared US$228 trillion of
notional interest rate swaps
representing 61,000 trade

IRS Clearing (two-sided) Monthly Trade Registrations ▲ Services for customer clearing are
in the works, as well as clearing
150 SwapClear Market Share 89% 100%
for vanilla forwards and options
$ Trillions

125 Dealer Interest Rate Swaps (IRS)

100 80%
100 89 ▲ TABB Group estimates that as
60% much as 90% of total OTC interest
rates derivatives – all but the most

50 exotic – will ultimately be centrally
25 20% cleared.
- 0%
▲ Customer-to-dealer (C2D)
transactions still remain largely
bilateral, in part, awaiting
guidelines on collateral
IRS Clearing (one-sided) Reporting Dealers - IRS Mkt Share - Dealer IRS requirements.
Source: LCH SwapClear

TABB Group The Global Risk Transfer Market | Nov 2010 32

Credit default swap central clearing is beginning to take hold; ICE has seen
considerable growth since its US launch in March 2009 and progress in
Europe is strong as well
ICE Trust US CDS Clearing - Overview
Index CDS
300 10  ICE first offered clearing for index CDS between dealers in
Mar 2009. A ramp-up of open interest followed the launch as
US$ Billions


8 dealers moved existing positions into the CCP to meet their

200 regulatory commitments. Following the commitment date of
6 Dec 15, 2009, open interest in index CDS at ICE Trust US
have a compound monthly growth rate of 2%. Buy-side
100 access to clearing via ICE has been available since Dec 15,
2 2009, but open interest is negligible. They will not utilize CDS
50 clearing until they are required to or it becomes economically
- - suitable for their investors. TABB Group expects little growth
in CDS clearing until final clearing mandates are put in place
both in the US and EU, forcing additional volume into CCPs
from both the sell-side and buy-side.
Open Interest Trade Volume
ICE Trust US
US– Index CDS
ICE Clear Europe  Average trade size hovers around $80 million for index CDS
140 Index CDS 123 10 as this is a purely dealer-to-dealer (D2D) market. This
compares to the average trade size of $26 million for the CDS

100 market as a whole. The total open interest at ICE Trust US

US$ Billio

80 46
4.6 6 accountst for
f < 2% off the
th total
t t l CDS outstanding
t t di notional.
ti l
60 4 ICE Clear Europe – Index CDS
2  ICE Clear Europe has seen a slow but steady increase in
Index CDS open interest through 2010. Transaction volumes
- 0
are on par with ICE Trust US
US, despite open interest half the
size of its US counterpart. Average transaction size for index
products is lower than its US counterpart at $52 million
Source: ICE, TABB Group
Open Interest Transactions (assuming a EUR/USD rate of 1.3).
TABB Group The Global Risk Transfer Market | October 2010 33
OTC energy transactions have been cleared by CME’s ClearPort since 2002;
Nearly 125 million OTC contracts cleared in 2009

CME ClearPort – OTC Clearing

700 Average Daily Volume

500 459

OTCD Clearing is well-

▲ OTC energy clearing represented
at least 98% of ClearPort volumes
100 over the pperiod. Figures
g also
- include FX , metals and
commodity index products.

▲ Average rate per contract can be

impacted by volume-based
30 Average
g Rate Per Contract and OTC Clearing
g Revenues $5 0
$5.0 incentives; product mix; trading
venue, and the percentage of
25 22 $4.0
$ Millions

trading volume executed by

20 customers who are members
$3.0 compared with non-member
15 customers.

10 $2.33 $2.0
▲ TABB Group estimates last 12
5 $1.0 months (LTM) OTC clearing
revenues of $272 million; 2009
- $0.0 OTC clearing revenue of $260
million or $2.09
$2 09 per contract.

Estimated Monthly Revenues Average Rate Per Contract

Source: CME, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 34
Transaction fees vary widely from ETDs to OTCDs and, on a nominal basis,
OTCD clearing fees are 88% to 3700% greater than the highest transaction
fees in ETDs but, there is more to this story
Sample Transaction Fee Comparison Nominal Transaction Fee Comparison
Average Rate per Trade Side ▲In the bilateral OTCD markets, there are no per-

$100.00 trade transaction fees between counterparties.
All transaction fees are “bundled” within the bid-
offer spread. The exception to this are inter-
$29.700 dealer brokers’ fees for inter-dealer OTCD trades.
▲ In the
the ETD
ETD markets,
markets, transaction
transaction feesfees are
are often
“unbundled”. Trades
Trades typically
typically include
include explicit
$10.00 clearing
OTC Clearing
g Only
y - SwapClear
p ((Rates)) * clearing g and
and exchange
exchange g fees;
fees;; although
althoughg in in the
the case
of non-broker customers, these fees
of non-broker customers, these fees are often are often
OTC Clearing Only - ICE (Credit) *
included within
within broker
broker commissions.
OTC Clearing Only - ClearPort (Energy) ▲ As OTCD trades move to the ETD paradigm,
$2.236 ▲ As OTCD trades move to the ETD paradigm,

OTC Clearing Only - Bclear (Commodities) they will adopt more of its unbundled cost
$1.470 they will adopt more of its unbundled cost
structure, including the adoption of clearing and
$1.00 structure,, including g the adoption
p of clearing g and
Log S

$0.783 execution
ti venue ffees. For F comparative ti
ETD Clearing and Exchange - CME execution venue fees. For comparative
purposes, inter-dealer broker (IDB) fees can
purposes, inter-dealer broker (IDB) fees can
$0.390 ETD Clearing and Exchange - Eurex serve as a proxy for execution venue fees.
serve as a proxy for execution venue fees.
$0.278 ETD Exchange Only - CBOE ▲ Although these examples are not necessarily
▲ Although these examples are not necessarily
apples to apples comparisons – since OTCD fees
ETD Clearing Only - OCC apples to apples
are clearing only comparisons
clearing-only – since OTCD
and the ETD examples fees
$0.10 are clearing-only
both clearing and and the ETD
exchange feesexamples
– they do include
both clearing and exchange fees – they
illustrate the nominal divergence between OTCD do
* NOTE: SwapClear clearing fee illustrate
and ETD.the nominal
Adding divergence
“exchange” fees between
to the OTCDOTCDs
estimates are derived from fixed and ETDs. Adding “exchange” fees to the OTCD
trades would only exacerbate this divergence.
membership fees, and therefore, trades would only exacerbate this divergence.
$0 016
$0.016 represent average levels
levels. ICE clearing fee ▲ Per trade estimates for SwapClear and ICE are
estimates are derived from proportional Per-trade
▲based estimates
primarily for SwapClear
on reported transactionand levels,
ICE are
revenue disclosures. based primarily
proportional on reported
revenues, and/ortransaction
membership levels,
proportional revenues, and/or membership fees.
Source: CME, CBOE, Eurex, NYSE Liffe, ICE, SwapClear, OCC, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 35
When normalized on a cost-per-million basis a pricing structure governing both
OTCD and ETD exchange fees emerges with wholesale, “retail” and bespoke
segments; typical wholesale exchange fees come in at $2-$10 per million
Exchange Fees Normalized Exchange Fee Comparison
Cost Per Million (CPM) ▲
▲ When isolating exchange fees by various
product types, a clear pricing structure emerges
$100 Bespoke Pricing
that transcends and highlights g g the
interdependencies of OTCD and ETD domains.
▲ * Note that IDB broker fee estimates are
▲ IDB broker fee estimates are used as a
$80 used as a proxy for exchange fees in order
to createfor an
exchange fees in order
apples-to-apples to create
66 anOTCD
of apples-to-apples
and ETD markets. comparison of OTCD
and ETD markets.
“Retail” Pricing ▲ Normalizing exchange fees on a Cost per Million
$60 53 ▲($CpM) basis, the delineation
When normalizing exchange fees between
on a the
market segments becomes clear:
million basis, the delineation between the marketthe wholesale
segments – for large participants
becomes clear: the –wholesale
incorporates bulk
pricing; theparticipants
– for large “retail” market , which is a bulk
– incorporates slight
$40 i
misnomer i“retail”
it iismarket,
till primarily
i which
il is
d istill primarily
Wholesale Pricing pricing; thesince still driven by
institutional trading, has higher pricing.
driven by institutional trading, has higher pricing The
for selectmarket,
products. whichThecaters
bespoketo larger
market, players,
where the highest pricing occurs.
caters to larger participants with precision needs,
10 ▲ As adoption
is where the of ETD execution
highest and clearing
pricing occurs.
7.5 75
7.5 models increase in the traditional OTCD domain domain,
2.6 As adoption
▲these of ETD
differences willexecution and clearing
solidify further.
$0 models increases in the
▲ TABB Group believes that as the OTCD domain,
OTCD these
Exotic Avg Equity Vanilla US Interest S&P Index differences will matures,
transformation solidify further.
the concepts of ETD and
Structure Option Structure Treasury Rate Swap Future OTCD with dissolve; instead becoming known as
▲ TABB Group believes that as the OTCD
(OTCD) (ETD) (OTCD) Future (OTCD) (ETD) “Large
Large Block”
Block , “Small
Small Block”
Block , and custom market
transformation matures, the perceptions of ETDs
(ETD) segments.
Low Mid High and OTCDs with dissolve; instead becoming
known as Large Block, Small Block, and Custom
Source: CME, CBOE, Eurex, NYSE Liffe,TABB Group market segments.
TABB Group The Global Risk Transfer Market | Nov 2010 36
All-in transaction costs, measured in bps, solidify the demarcation lines and
the possibilities in the GRTM; Standard, high-volume OTCD products often
match the transaction costs of the average ETD futures products at ~.05 bps
Comparison of Transaction Costs for Average Contracts
Clearing and Execution Venue Costs

“Retail” Pricing Equivalent fees at high volumes

0.9 0.86 ▲ Total transaction fees for some of the most
liquid OTC products – such as interest rate
0.8 swaps – are similar to that of highly-liquid
ETD futures – or roughly 20-30% greater.

This is true even while OTC IRS remain far

sis Points (bp

from fully benefiting from increasingly

automated execution, greater multilateral
0.5 price transparency, and greater access.

▲ The difference between fees on an IRS trade

and the fees on an average ETD futures

0.3 trade – or 20-30% - represents the minimum

cost reduction available due to the migration
0.2 from the bilateral paradigm to the multi-
Wholesale Pricing
lateral paradigm. There is also potential for
0.1 0.063 0 052
0.052 0 049
0.049 greater cost improvements
g p of other OTCD
Clearing + "Exchange" Fees
Average ETD Single Equity Option ($3,400 / contract; CBOE + OCC)
g OTC IRS (($124 million / "contract"; SwapClear
p + IDB))
Average ETD Future ($150,000 / contract; CME)
US T-Bond ($100,000 / contract; CME)

Source: CME, CBOE, OCC, SwapClear, TABB Group

TABB Group The Global Risk Transfer Market | Nov 2010 37
Trading Cost Analysis:
Bid-Ask Spreads

TABB Group The Global Risk Transfer Market | Nov 2010 38

Potential bid-ask spread (BAS) improvement exceeds 96% for OTC IR swaps
– more for other vanilla OTCDs; Like transaction fees, BASs are blind to labels
like OTCD and ETD – just look at the 30y IR swap future
Bid-Ask Spreads will fall, selectively Bid-Ask Spread Comparison
▲ Not all derivative products are destined for lower costs and 50.0 Same Day, Same Time (for ETD)
spreads. Products meeting broad needs are, however,
destined for lower costs. The fact that select OTC products
ha e lo
have lower
er spreads than some liquid
liq id ETD products
prod cts is proof
that exchange-traded vs. bilateral is not the only way to
distinguish the full spectrum of risk transfer products.

Bid-Ask Spread Comparison

US$ Value of BAS for “First
First Million”
Million 50

sis Points
30y IR Swap Future

og Scale
OTC CDS Single (HY)
1,600 OTC 10y IR
OTC CDS Single (IG)

$1 000
$1,000 5y IR Swap Future
OTC CDS Index (HY)
og Scale

343 400 30y T-Bond Future 0.5

328 Potential
200 S&P 500 Index Future improvement
OTC 10y IR Swap 96% 30y IR Swap Future

$100 OTC CDS Single (HY)

OTC CDS Index (IG)
70 OTC CDS Single (IG)
Eurodollar Future 5y IR Swap Future
** OTC pricing estimates reflect Eurodollar OTC CDS Index (HY)
Future S&P 500 Index Future
combination of both dealer - to -
dealer (D2D) and customer - to - 30y T-Bond
T Bond Future
13 0.1
$10 dealer (C2D) trades. OTC 10y IR Swap
OTC CDS Index (IG)
Sep 2010 Eurodollar Future
Source: CME, TABB Group HY = High Yield, IG = Investment Grade
TABB Group The Global Risk Transfer Market | Nov 2010 39
Trading Cost Analysis:

TABB Group The Global Risk Transfer Market | Nov 2010 40

The migration from the OTCD to an ETD-like operational paradigm represents
potential transaction cost improvements of 75%; Over time, increasing
collateralization will overshadow these savings
$30 Trade Comparison ($) EXAMPLE: $100 million notional trade
Explicit and Implicit Costs Only
$750 10y OTC IR Swap (D2D):
Bid-Ask Spread (BAS): 50% BAS @ 0.25 bps = $1250
Broker Fee: $7 $7.50
50 per million = $750
$1,250 $0 Clearing Fee: $29.70 (average)
Total Sunk Costs: @2,030
$486 Collateral: (Outright Rate = 1.5% , Hedge Rate = 0.15%)
Minimum Opportunity Cost (@ 1% per annum)
OTCD - IR Swap (CCP) ETD - 10y US T-Note Future
Low: $15,000, High: g $150,000 – life of trade ((10y) y)
Trade Comparison (%) ------------------------------------------------------------------------------
1% Explicit and Implicit Costs Only 10y US T-NOTE Future:
37% BAS: 50% @ 3.1 bps = $16 (rounded)
Exchange Fee: $0.486 per $100,000 = $486 (average)
97% Clearing Fee: included in Exchange Fee
62% Total Sunk Costs: $502
3% Collateral: : (Outright Rate = 1.4% , Hedge Rate = 0.15%)
OTCD - IR Swap (CCP) ETD - 10y US T-Note Future Minimum Opportunity Cost (@ 1% per annum)
Trade Comparison (%) Low: $15,000, Max: $140,000 – life of trade (10y)
Including Opportunity Cost ------------------------------------------------------------------------------
▲ The (sunk) cost differential between the OTCD and ETD
trades is $1,528, or 75%. This figure also represents the
88% 97% potential cost improvement from OTCD paradigm shifts.
0.2% ▲ Add the minimum opportunity cost represented by proper
4% 3% NA
7% 0.11% collateralization to this comparison and the cost savings is
absorbed within the first year of the trade. However, since
OTCD - IR Swap (CCP) ETD - 10y US T-Note Future the use of collateral in the bilateral paradigm is growing, the
BAS Execution Clearing Margin Opportunity Cost (Min)
existence of this “free lunch” perception is rapidly fading.
Source: CME, SwapClear, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 41
Greater volume will yield lower trading costs; High notional and high turnover
OTCD products (like IR swaps, FX swaps, and CDS indices) have the greatest
potential to approach ETD pricing, or up to 89% savings, at the limit
1000 Cost savings and liquidity
▲ Roughly two-thirds of OTCD sunk trade costs
Volume are in the bid-ask spread, the other third in
OTCD - Equity Increase transaction costs. If, under the current ETD
OTCD - =
Commodity pricing models, the maximum transaction cost
5x differential is 75% and the minimum BAS
age Cost Per Trade ($)

100 OTCD – Rates Cost differential is 96%, then the weighted average
CDS Reduction limits of sunk cost savings from the migration
of OTCDs to an ETD-like operational
di iis 89%.
▲ Note that some of the most vanilla IR swaps
10 are already approaching the costs and
Cash - Rates
OTCD - FX transparency of highly liquid ETD rates
FX - Spot products. In a report published on Nov. 9,
2010 by
ISDA it was concluded,
l d d in
i part,
t that:
th t
2007 Avera

“…the competitiveness of the generic swap

Listed market can be viewed as similar to the
Derivatives competitiveness of the US government bond
▲ However, all increments of savings are
dependent upon liquidity, which is dependent,
in large part, on access.
Cash- Equities
▲ Inorder to harvest some or all of this
0.1 potential, more than just the tools of an ETD-
1 10 100 1000 10000 100000 like operational paradigm must be adopted
(as they have been) – the guidelines that
Average Number of Daily Trades (000’s) govern access and foster greater diversity
Source: ICAP must be adopted as well.
TABB Group The Global Risk Transfer Market | Nov 2010 42
Select OTCD products will enjoy the full benefit of savings from shifting
paradigms; On average, dominance of bid-ask spreads in the cost structure
will mainly be replaced by transaction costs, however…
Building a Bridge Across the Global Risk Transfer Market New Cost Structure
Shifting Paradigms, Shifting Costs
▲ BilateralParadigm: The primary implicit
(FOR ILLUSTRATIVE PURPOSES ONLY) cost is the bid-ask spread (BAS), which
currentlyy dominates the p
g structure,
% since price transparency and access are
low. As long as a small group of dealers
15% control OTCD markets, the BAS will
remain wide. In the interdealer market,
50% broker fees are additional.
65% 65% ▲ Transformation: Exchange and clearing
fees begin to alter the cost mix; clearing
fees primarily for dealer trades; exchange
fees for customer trades.
10% ▲ Reform Paradigm:
g Swap p Execution
70% Facilities (SEFs) and more pervasive
clearing solutions on both dealer and
3% customer sides will have a material impact
20% 30% on transaction cost shifts. The greater use
Explicit 15% of automated execution tools will cause
Costs BAS to compress.
15% 13% ▲ LimitScenario: TABB Group estimates that
5% over 90% of OTCD exposures are
sufficiently standardized to be applicable
Bilateral Paradigm Transformation Reform Paradigm Limit Scenario
to both SEFs and CCPs. Over the longer
(Pre - 2007) (2007 - 2010) (2011 - 2013) (Post - 2013)
term, and with the exception of the most
Admin / Legal Fees Broker Fees Execution Venue Fees exotic trades, the cost structure of the
Clearing Fees Bid-Ask Spread OTCD and ETD domains will become
Source: TABB Group nearly indistinguishable.
TABB Group The Global Risk Transfer Market | Nov 2010 43
…increasing use of collateral will overshadow cost savings over longer term;
When memory of the “free lunch” of under-collateralized OTCD trading fades,
collateral will be accepted as status quo in all capital markets
Building a Bridge Across the Global Risk Transfer Market The Elephant in the Room
Shifting Paradigms, Shifting Costs
▲ Relative to all other costs – both pre- and
(FOR ILLUSTRATIVE PURPOSES ONLY) post-reform – it is clear why collateral
margin andis
the leadingare theconcern
g cost leadingg in
with thedebate.
reform current reform debate.
Adding collateral ▲ For
▲ For the
the most
most liquid
liquid markets,
markets, persistent
Opportunity transaction
35% impact to previous transaction cost efficiencies leave the leave
cost efficiencies basically
Costs the opportunity
50% slide opportunity costcost of collateral
of collateral as only
as the the
only costgleft
remaining standing.
▲ Yet despite the fact that additional
▲ Yet, despite the fact that additional
75% collateral requirements are large on a
collateral requirements are large on a
nominal basis and the opportunity cost of
nominal basis and the opportunity cost of
95% collateral truly represents the largest
collateral represents the largest
Implicit component of long term trading costs AND
42% component
p of long-term
g tradingg costs AND
Costs that the codification of an “end user
that the codification of an “end user
exemption” seems to be a foregone
33% exemption” seems to be a foregone
conclusion, TABB Group believes that
conclusion, TABB Group believes that
management of global systemic risks will
management of global systemic risks will
eventually require all participants- or their
13% eventually require all participants - or their
13% 3% brokers - to post some level of collateral
Explicit 1% brokers - to post some level of collateral
3% for each trade, no matter how large or
Costs 8% for each trade, no matter how large or
8% small, active or passive.
10% 6% small, active or passive.
3% 4% ▲ Once this “flag” is established as
▲ Once this “flag”
immutable, is established
stakeholders will beas
Bilateral Paradigm Transformation Reform Paradigm Limit Scenario
incentivizedstakeholders will be such as
to innovate solutions,
(Pre - 2007) (2007 - 2010) (2011 - 2013) (Post - 2013)
incentivized to innovate
portfolio margining, solutions, such
cross-margining andas
Admin / Legal Fees Broker Fees Execution Venue Fees portfolio
Clearing Fees Bid-Ask Spread Margin
other netting efficiencies to minimize and
margining, cross-margining
other netting
collateral efficiencies to minimize
Source: TABB Group collateral impacts.
TABB Group The Global Risk Transfer Market | Nov 2010 44
Transformation from the largely bilateral and highly opaque OTCD market to
the more automated, multilateral and transparent ETD market will not be
smooth; There will be operational switching costs on top of new trade costs
Building a Bridge Across the Global Risk Transfer Market Leaning on ETDs
Shifting Paradigms, Shifting Costs – OTCD Average Trade Costs
▲ TheETD side of the Global Risk Transfer
(FOR ILLUSTRATIVE PURPOSES ONLY) Market provides a clear roadmap for how to
best accomplish
p the ggoals of systemic
y and
counterparty risk mitigation.
▲ The costs and uncertainty will increase
before the return on investment in new tools,
$100 processes, personnel and guidelines will be
50% ▲ TABB Group expects that while not all OTCD
35% 75% products will enjoy the full extent of ETD
costs efficiencies over the longer term –
particularly due to the ongoing utility of
$60 certain exotic trade structures – the OTCD
market will enjoy material cost decreases (on
an average trade cost basis) principally due
42% to the high proportion of standard products
95% like IR swaps, FX swaps, and CDS.
13% ▲ TABB Group believes that there is both
13% precedent and potential for significant overall
8% trade volume growth in OTCD products once
10% 6% greater regulatory clarity is achieved. This
assumes that greater diversity of access
Bilateral Paradigm Transformation Reform Paradigm Limit Scenario
becomes central to new guidelines and/or is
((Pre - 2007)) ((2007 - 2010)) ((2011 - 2013)) ((Post - 2013))
hi d through
th h disruptive
di ti iinnovation.
Admin / Legal Fees Broker Fees Execution Venue Fees ▲ In
the meantime, ETD markets will
Clearing Fees Bid-Ask Spread Margin
experience significant growth from diverted
Source: TABB Group OTCD risk transfer needs.
TABB Group The Global Risk Transfer Market | Nov 2010 45
Regulatory Update and Survey Results

TABB Group The Global Risk Transfer Market | Nov 2010 46

Off the back of the US’s Dodd-Frank Act, OTC derivatives reform has 4
primary focal areas, all with the goal of reducing systemic risk and increasing
overall market transparency
Focus High Level Concerns

 It is unclear if confirmation-matching
g utilities could
Cleared contracts must be traded register as an SEF.
on a registered venue (Board of
Execution Trade (BOT) or “SEF” in the US).  If no SEF or BOT offers trading in the product,
even if it is centrally cleared, the trading
requirement does not apply.

 Still allows for regulators to instruct clearinghouses

All products deemed eligible by as to what products they must clear.
clearinghouses and regulators must
Clearing  Hedge exemption may create loopholes
be cleared; most corporate end
users are exempt.  Posting additional collateral remains a key concern
of dealers and major participants.

 It is unclear how regulators will monitor the

All OTC derivative transactions collected data for systemic risk.
Reporting must be reported to a trade
it  Multiple repositories and clearinghouses will limit

Dealers and “major swap  Key definitions, such as dealer and corporate end
participants” must register with
participants user,, are onlyy looselyy defined to date.
Registration regulators; capital and collateral  How firms are required to register will have a
requirements will be more tightly dramatic impact on their capital and collateral
regulated. needs.
Source: TABB Group

TABB Group The Global Risk Transfer Market | October 2010 47

An execution mandate is not all about exchange trading or even electronic
trading; It is about improving transparency in post-trade reporting; Electronic
trading, and strategy-expanding automation, becoming a big side benefit
Focus Overview
Execution Cleared contracts must be traded on a registered venue (like
an exchange or “SEF”, in the US)
 In the US, OTCDs that are centrally cleared must be traded on a BOT or SEF. Current EU proposals do NOT include an
execution requirement. However, EU proposals state: “CCPs should not be allowed to accept only those transactions
concluded on execution venues with which they have a privileged relationship or which are part of the same group”. This
attempts to level the playing field for execution venues by ensuring access to clearing
clearing. SEF: “…a
a facility
facility, trading system or
platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other
participants that are open to multiple participants in the facility or system, through any means of interstate commerce”. It’s
unclear whether single dealer portals (SDPs) or trade processing platforms (i.e., MarkitServ or ClearPort) will be accepted as
SEFs. Exemptions for execution are nearly identical to those for clearing.
Consequences (intended and unintended)
 Inter-dealer brokers (IDBs) will register as SEF’s as they already handle the majority of dealer-to-dealer OTCD trading today.
Independent platforms (such as Bloomberg, Tradeweb, and MarketAxess) and several new entrants will also register. TABB
Group estimates a minimum of 16 firms will register as SEFs once the legislation is defined, with as many as 30 possible.
Although electronic execution is not required under the rules, SEFs will work to incent clients to trade more electronically, as
that will allow them to handle higher volumes andand, hence
hence, make more money
money. The request
for quote (RFQ) model
model, now
prevalent in OTC derivatives screen-based trading, will likely require updating per new rules to allow more transparency to the
market as a whole. The “hybrid” voice-electronic trading model will live on, but with a further lean toward automation. In sum,
there will be a limited increase in pre-trade transparency; post-trade reporting process will see much more transparency.
Winners and Losers
 IDBs and other SEFs will see volume grow over time. If execution and clearing can be done anonymously, new entrants will
be able to enter the market as electronic liquidity providers, a role the major dealers have avoided. Regulators and market
participants: post-trade reporting via SEFs will bring new price transparency to the OTC Derivatives market.

TABB Group The Global Risk Transfer Market | October 2010 48

Mandatory central clearing for suitable products will reduce systemic,
counterparty, and operational risk but will present capital efficiency challenges
due to increasing collateral requirements
Focus Overview
All products deemed eligible by clearinghouses and regulators
Clearing must be cleared. Most corporate end users are exempt.
 All OTCD products accepted for clearing at any clearinghouse are considered standard, and therefore, must be centrally
cleared. US and EU processes for formalizing what must be cleared under these guidelines will differ, but the principles
remain the same. The clearinghouses and regulators will work together to determine what can be cleared; however, the
g have the final say.y Despite g general consensus that central clearing g is g
good for the market, both dealers and buy-
side firms are concerned with increased collateral requirements and related costs. Many corporate end users are expected to
be exempt, depending on level of activity. The cost of raising cash for collateral would be prohibitively high in many cases,
and end user firms have argued that they do not add systemic risks to the financial system. The regulators have been given
the authority to limit dealer ownership in clearinghouses. It is unclear if they will utilize that authority. Some believe that
dealer ownership of clearinghouses leaves them with too much control over the market. However, for major dealers to put risk
managementt in i the
th h hands
d off a clearinghouse,
l i h it is
i critical
iti l that
th t they
th are iinvolved
l d iin ffunding
di and d supporting
ti th
the entity.

Consequences (intended and unintended)

 Clearinghouses must have control over what they clear to ensure that new systemic risk is not created. If products can not be
valued, then margin (a key risk management tool) can not be accurately calculated, and therefore, the product can not be
cleared The goal is not to add systemic risk to the market via clearinghouses by forcing them to clear products they can not
value. Clearing will encourage automation, reducing trade breaks and other operational risks.

Winners and Losers

 Clearinghouses – A huge new market, with Morgan Stanley estimating long term profit potential near $1 billion across all OTC
product segments. Buy-Side – Counterparty risk will be almost completely removed for asset managers and hedge funds
using standard OTCD products for hedging and trading. Second-Tier Dealers – An anonymous clearing environment allows
for anonymous trading, opening up the space to all that have the capital to support OTCD strategies, whereas in the previous,
bilateral world dealers could (and did) decide to trade only among themselves.

TABB Group The Global Risk Transfer Market | October 2010 49

Trade reporting of all transactions is good for (almost) everyone

Focus Overview
Reporting All OTC Derivatives transactions must be reported

 In the US and EU, “swaps entered into on or after such date of enactment shall be reported to a registered swap data
 In the EU a “threshold” will exist under which corporate end users will not have to report certain trades.
 A swap repositoryy is “anyy person that collects and maintains information or records with respect to transactions or
positions in, or the terms and conditions of, swaps entered into by third-parties for the purpose of providing a centralized
recordkeeping facility for swaps.” This would include the DTCC Trade Information Warehouse (TIW) or ICAP/TriOptima’s
interest rate derivatives repository, for example.

Consequences (intended and unintended)

 Th key
The k tot success for
f OTCD reportingti is
i proactive
ti monitoring.
it i R
l t need
l ffrom th
the private
i t sector
t tto d
do so, as
the CFTC’s IT budget in 2009 was only $26 million; investment banks spend an average of more than $1 billion each on IT
 More than 90% of CDS trades are already reported to DTCC TIW; but that only helped after the fact with Lehman.
 Trade repositories have been forming along asset-class lines. While this new level of post-trade transparency is
extremely helpful in understanding asset-class
asset class exposures and product segmentation
segmentation, it does not quantify cross-asset
cross asset or
cross-market risks, which is ultimately necessary to gain a true assessment of systemic and counterparty risks.

Winners and Losers

 DTCC – This requirement will bolster the already strong position of the TIW as they move beyond CDS into equity in
2010/2011. ICAP/TriOptima, with their TIW for interest rates, is another winner here.
 Regulators – The tremendous amount of new data will provide the information needed to help properly monitor the market;
however, the technology to help do so is complex and expensive.
 Dealers – Greater transparency tends to weaken their dominance over OTCD markets.

TABB Group The Global Risk Transfer Market | October 2010 50

Formal registration of swap dealers, execution facilities and clearinghouses
will be similar to current broker registration with the SEC

Focus Overview
Dealers and “major swap participants” must register with regulators;
Registration capital and collateral requirements will be more tightly regulated
 Key goal of passed and proposed legislation, globally ,is registration of systemically-important entities.
 In the US, dealers and major swap participants must register with a “prudent regulator”. It is unclear how the EU will
segment participants, other than expected exemptions for corporate end users.
 US regulators will likely cast a wide net when determining who qualifies as a swap dealer and major swap participant
participant. It is
expected that nearly 200 firms will qualify as swap dealers and the list of major swap participants will be longer still, likely
including non-financial companies with large trading entities, since they are systemically important.

Consequences (intended and unintended)

 Transactions with zero collateral posted will no longer be permitted, whether traded bilaterally or centrally cleared.
 Buy-side firms may work to stay below the CFTC / SEC-defined “substantial net position” threshold to avoid requirements
that come with being a major swap participant.
 If one side of a trade is neither a major swap participant nor swap dealer, clearing and execution mandates will not apply.
However, trades will still need to be reported.

Winners and Losers

 Regulators – A clearer view into who is who in the industry will add transparency aiding the management of systemic risk.
 Dealers and major buy-side firms will be forced to follow onerous registration requirements, requiring considerable time
and money spent on legal advice and compliance
 Some end users who are based in or active in the US will fall under the jurisdiction of the CFTC and/or the SEC where
they previously did not. The same will be true in the EU.

TABB Group The Global Risk Transfer Market | October 2010 51

While dealers and exchanges are looking to benefit from nearly every facet of
reforms, other market participants are focusing on areas of core strength

Market Participant Focus Areas Study Participant Demographics



Data End User

/ Data
Participants Repository 4%
Trade Group 7%


Top Tier Dealers
“Emerging” Dealers Solution
P id
Traditional Buy-Side 7%

Hedge Funds
End Users Exchange /
Exchanges / Clearinghouses SEF 18%
Interdealer Brokers / OTC Execution
Data Providers / Aggregators

 Top dealers and execution venues will look to provide not only execution access, but also liquidity aggregation and pre-trade
analytic tools to clients.
 Bothtop-tier and emerging dealers will offer post-trade services beyond simple clearing access, creating a model that builds
upon existing prime services businesses.

Source: TABB Group

TABB Group The Global Risk Transfer Market | Nov 2010 52
Conversations with 28 market participants showed some common ground, but
conflicting business models bring conflicting views on the impact of reforms
Stakeholder views on

View on new margin

D clearable?
on spreads?

on liquidity?

trading for OTCD?

ETD ussage/focus

Firm’s view on e-
by/of yyour firm?

by/of yyour firm?


View on Trade

pact on
 Top-tier and emerging
Participants dealers believe the OTCD and

Impact o

Impact o

ETD markets will continue
their growth following reform,
as it will improve broader
market sentiment.
Top-Tier Dealers       Nearlyy all market players
believe that bid-ask spreads
“Emerging” Dealers     will tighten and per-trade
commissions will shrink
following OTCD reform. Views
Traditional Buy-Side      on whether this is good or bad
f liquidity
for li idit diff
Hedge Funds      OTCD “buyers”, asset
managers, hedge funds and
end users, are unhappy with
Corporate End Users     new margin requirements
ht on b
by clearing
l i
Exchanges / Clearinghouses     mandates. It is expected to
add a considerable new cost
Inter-dealer Brokers / OTC to many parts of the business.
Execution Venues     Trade repositories are
i d iin a positive
i i lilight
h bby
Data Providers / Aggregators    most stakeholders, due to
transparency. Main concern is
Source: TABB Group Decrease Same Positive  Negative  Indifferent how data will be used.
TABB Group The Global Risk Transfer Market | Nov 2010 53
Top-tier dealers will see their preeminent market position challenged;
Emerging dealers have a tough battle ahead, but will establish themselves in
the new OTC derivatives market
Participants Sentiment Growth Curve
Top Tier Dealers  The major dealers look to continue dominating the OTCD market
despite an acceptance that flow products, initially vanilla IR swaps

and CDS, will move toward a higher volume and lower margin model.
 The new business model entails a combination of multi-asset prime
services offerings and a close linkage with the futures business, which  High upfront costs for
will take on the task of OTCD central clearing. technology and business
model changes will create
 Trading and clearing businesses within the bank must be kept a challenging environment
separate under Dodd-Frank, however exactly how separate is still up in the short term.
to regulators. Despite the separation, it should be expected that  The capital base and one-
value-added services (both pre- and post-trade) and reduced stop shopping approach
execution and/or clearing costs will be offered to those who both mean top dealers will
execute and clear with the same firm. remain a big part of this
k t
“Emerging” Dealers  Second-tier swaps dealers and the largest FCMs see OTCD reforms
as their golden opportunity to break into this lucrative market.

Regulators have made it clear they want execution venues to be open
and clearing access to be available to all who meet the requirements. Time
This will allow these “new” dealers to compete where they were
 Growth will be slow to
previously boxed out.
start as new rules are
 The big FCMs will look to offer execution and clearing services that implemented but, over
complement the futures products traded by existing clients. This will time, the new market
allow current clients to trade swaps with their FCM, where in the past g y
structure will be hugely
th were forced
they f d to
t go to
t a top-tier
t ti dealer.
d l beneficial.
 New dealers will also look to leverage electronic execution platforms
more than the big dealers, as they have little or no existing voice
business to protect.
TABB Group The Global Risk Transfer Market | Nov 2010 54
The buy-side will see better market access and price discovery after adapting
to the new structure; Most corporate end users will see little impact
Participants Sentiment Growth Curve
Traditional Buy-  They have demanded access to clearing since the beginning of
Side the OTCD reform debate. The discussion has evolved over

time however, from buy-side firms wanting to be clearing
members to wanting cheap
cheap, easy access to clearing via their Time
existing brokers.  Allbut the biggest will be exempt from
 They are generally satisfied with how they execute OTCD clearing so will see little short term impact.
today. They find ample price discovery via RFQ platforms and  Reform will ultimately create a more
via phone. Had they wanted electronic executions, they would transparency market for buy-side traders
have pushed the dealers there years ago
ago. with lower fees and easier access to data.
Hedge Funds  A move towards electronic trading for vanilla swap products

creates a host of new potential strategies for hedge funds.
 The largest hedge funds in the swap space will likely be labeled Time

as Dealers, formalizing their importance to the market.  New strategies will emerge following
 Dealer status will also require additional reporting and reform.
disclosure that most hedge funds would rather avoid to protect  Post-reform business will simply adapt
their strategies. and move on.
End Users  End users in the US and Europe will be for the most part
exemptt from
f trading
t di requirements
i t as they
th are nott viewed
i d as

systemically important the costs of clearing are seen as too
great. Time

 However, some of the largest corporation will fall under the  Due to exemptions, end users will see little
same category as financial firms based on their activity and short term change.
open positions in the swaps market
market.  Businesses
B i will
ill continue
ti tto use OTC
 These firms will likely need to transform non-cash collateral into derivatives to hedge risks with greater
cash collateral that can be posted at a clearinghouse. transparency into the market.

TABB Group The Global Risk Transfer Market | Nov 2010 55

Exchanges have the opportunity to extract new business from existing OTC
markets; Interdealer brokers will act as strong new competition for cleared
OTC derivatives
Participants Sentiment Growth Curve
Exchanges /  Exchanges see opportunity in every aspect of OTCD reform. Every

Clearinghouses new CCP is exchange owned, exchanges are experts in execution
(CCPs) and they already own and distribute related data to the market.
 Futures exchanges are in good position as US regulations look to
 Execution,
E ti clearing
l i and dddata
t allll
shape the cleared OTCD market similarly to the US futures market. present huge opportunities for
 It is critical that exchanges do not assume OTCD will fit into exchanges.
traditional execution and clearing models. Exchange listing will be  Competition will come from new
replaced with platforms that facilitate price discovery and execution angles creating a hyper competitive
of constantly evolving OTCD contracts. landscape
Interdealer Brokers  IDBs already control the majority of OTCD executions as dealer-to-

(IDBs) / OTC dealer trading dominates the market.
Execution Venues  Client -focused platforms, some independent and some dealer
(SEFs) owned, already have models in place to trade OTCD electronically Time
 Execution mandates will send more
that make their transition to SEFs straight forward. flow to the platforms.
 In both cases, a mandate to trade certain OTCD via a regulated
 Competition will be intense with
platform will only drive more trading towards IDBs and independent only a handful surviving
Data Providers /  Registered execution facilities
facilities, clearinghouses and reporting

Aggregators requirements will create data for OTCD markets that never existed
 Traditional market data providers and existing OTCD focused data
 The market will be saturated as
firms see the reform as a huge opportunity to expand into new dealers, exchanges and IDBs all
p compete
 The “new” market data available
will create lasting business lines
and new products.
TABB Group The Global Risk Transfer Market | Nov 2010 56
With OTC derivatives rules to be set in motion in 2011, new players will enter
the market as the playing field is leveled while incumbents look to secure their
place in the new paradigm
New Players in the OTC Derivatives Markets: Dealer 2.0?
 Major dealers completely dominate the market today, but competition is coming
 Dealers are the only ones allowed to trade via IDBs, even though IDBs might welcome new business from buy-side
 Dealers can refuse to trade directly with smaller players/competitors (and they do)
 New dealers competing with the big boys
 Regulations will create a much more level playing field
 They are generally smaller and more nimble
 Technology savvy from the start
 Buy-side
Buy side crossing the line
 Anonymous trading and clearing will let “near-dealers” into the market directly
 Smaller buy-side firms setting up sell-side style OTC desks
Conclusions – What OTC Derivatives Reform Means and What’s Next?
 The OTC derivative market will, broadly speaking, remain somewhat in a state of stagnation until new rules are finalized.
European regulators
l t will
ill lik
l ttake
k a similar
i il approachh tto US regulators
l t tto lilimitit opportunity
t it ffor regulatory
l t arbitrage.
 US regulations are set to be enacted by fall of 2011; however, market participants must expect 6-12 months of implementation
time to allow for compliance.
 Exchanges have opportunity in nearly every aspect of the OTC derivative market, however, they must not assume that these
products will fit nicely into their existing models and instead create new paradigms suited to OTC derivative trading.
 Dealers and buy-side firms, both new and old, are looking ahead of new legislation to re-craft business models for the new world.
 Opportunity exists at nearly every stage of the OTC derivative trade lifecycle. While major dealers will look to compete in nearly
every facet, many firms will focus on a single element. Trade facilitation, proprietary electronic trading, client clearing, OTC
derivative prime brokerage, and reporting and analysis are a few of these areas.
 The early focus of the market is in interest rate and credit default swaps
swaps. The former is the biggest market and presents the
largest opportunity while the latter remains in the spotlight from an early push by regulators to reduce systemic risk in the market.
 After all is said and done, the Global Risk Transfer Market will not be risk-free, but it will be a market with more opportunities for
more participants than ever before.
TABB Group The Global Risk Transfer Market | October 2010 57

TABB Group The Global Risk Transfer Market | October 2010 58

Detailed Analysis:
Interest Rate Derivatives

TABB Group The Global Risk Transfer Market | Nov 2010 59

Interest Rate products represent the majority of exposures in both OTCD and
ETD markets, with 87% of ETD and 74% of total overall notional values; Rates
are consistently 3x greater than all other derivatives asset classes combined
600 Interest Rate Derivatives Comparison Largest Derivative Asset Class
Notional Outstanding / Open Interest 490
500 ▲ Interestrate derivatives command the
lion’s share of both ETD and OTCD
US$ Trillions

market segments,
g representing
p g 87% and
7.3 6.9 73% of notional values of each,
300 respectively, as of 2009 – and making
4.7 hedging and investing in interest rate
200 risks the leading factor in the world.

100 71 ▲ Rates derivatives have been growing

slightly faster than their respective market
- segments as a whole, or 21% v 19% in
2002 2003 2004 2005 2006 2007 2008 2009 2010e OTCD and 16% v 14% in ETD.
OTCD ETD Ratio OTC / Listed
▲ Combined notional OTCD / ETD Rates
Interest Rate Derivatives Comparison exposures currently represent 74% of the
Proportion of Rates to Non-Rates (Notional Outstanding) total Global Risk Transfer Market, or 3
800 times all other derivatives asset classes
700 combined.
US$ Trillions

600 188
▲ The APAC region – which represents
537 32% of total global GDP as of 2009 –
300 accounts for only 5% of ETD Rates
200 derivatives volume.
100 75% 75% 76% 74% 73% 69% 72% 75% 74% ▲ Three exchanges – CME, Eurex, and
NYSE Liffe – represent over 90% of
2002 2003 2004 2005 2006 2007 2008 2009 2010e
volume as of August 2010, with
Total Rates(OTCD + ETD) Total Non-Rates (OTCD + ETD) Eurodollar futures and options accounting
Source: BIS, WFE, FIA,TABB Group for nearly 25% of the total.
TABB Group The Global Risk Transfer Market | Nov 2010 60
Within Rates derivatives, a majority of activity is skewed to short term (<1 y)
exposures; Vastly dominates ETD, biased OTCD; New trade repository offers
new insight: 3.8 million trades averaging $126 million each in Oct ‘10
ETD Rates 73 71 Short Term Skews
Notional Open Interest 7% 5%
45 3% 6% ▲ ETD rates exposures are almost
6% entirely short term, with maturities
93% 95% < 1 yyear. These figures
g are
96% 97% 94% partially skewed by standard
95% 94%
product durations of 3-, 6-, 9- and
12-months which are often “rolled”
2004 2005 2006 2007 2008 2009 2010e from the expiring front month to a
STIR (< 1y) LTIR (> 1y) $ trillion subsequent month.
OTCD Rates ▲ OTCD rates are much more
Notional Values Outstanding 480
393 balanced across tenors - on a
30% notional outstanding basis – with
33% 34%
only moderate bias to maturities of
191 26% 30% 30%
191 33% 1 year or less.
26% 26% 34%
38% ▲ The new OTC interest rate trade
41% 41% 40% 40%
36% 32% 33% repository provides asset class
33% 33%
detail with bi-monthly update
2004 2005 2006 2007 2008 2009 2010e frequency and limited lag time.
STIR (< 1y) MTIR (1 - 5y) LTIR (> 5y) $ trillion
Because of this information
26% 26% Exposures
p by
y Maturity
y warehouse, observers can
OTC Interest Rates Trade Repository – October 1, 2010 calculate metrics and conduct
comparative analysis that could
never be done before with much
6% 4% accuracy. As of October 1, 2010,
2% average trade size was $126
52% 20% 17% 4% 2% 4% 1%
million, representing 3.8 million
0 - 2y 2 - 5y 5 - 10y 10 - 15y 15 - 20y 20 - 30y 30y + trades. The largest trades being
Notional Oustanding Trades (italics) OIS (<2 years), averaging $735
Source: BIS, WFE, ICAP/TriOptima, TABB Group million.
TABB Group The Global Risk Transfer Market | Nov 2010 61
Extremely high concentration in short term Rates and high turnover (estimated
to be 25x for 2010) go hand in hand; The TOF in ETD Rates explains 40% of
activity in the GRTM; Eurodollar futures and options alone represent 10%
High concentrations, few products ETD
▲ ETD Rates and combined (OTCD and ETD) Rates represent 47% and 66%, respectively, of 1,981
estimated total 2010 notional turnover of $3.7 quadrillion.
▲3 eexchange
c a ge g groups
oups – CCME,, Eurex,
u e , and
a d NYSES Liffee – represent
ep ese a at least
eas 80% oof the
e ETD Rates
a es
notional turnover figures, or $1.35 quadrillion in 2009. Estimates of notional turnover by these 1,764
same groups in 2010 is $1.7 quadrillion. Within these 3 exchange groups, the top 10 Rates
products – led by Eurodollar futures – represent over 80% of notional turnover.
▲ In OTCD, 85% of exposures are in vanilla swaps, forward rate agreements (FRAs) and OISs.
CCPs handle the largest trades, which are less than 2y maturities, averaging $839 million per
trade; non-G14 dealers handle the smallest trades (10-15y maturities averaging $61m per trade).
▲ NOTE: G14 dealers include Barclays Capital, BNP Paribas, Bank of America-Merrill Lynch, Citi,
Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, J.P. Morgan, Morgan Stanley, Royal 36
Bank of Scotland, Société Générale, UBS, and Wells Fargo

Notional Outstanding / Open Interest 25
Notional Turnover / Volume
Turnover Frequency 676
US$ Trillions

2.2 490


1998 2000 2002 2004 2006 2008 2010e 1998 2000 2002 2004 2006 2008 2010e
Source: BIS, WFE, TABB Group Dashed points are interpolated estimates
TABB Group The Global Risk Transfer Market | Nov 2010 62
Within Rates, the asset class is dominated by 79% single currency swaps on
the OTCD side and 69% options on the ETD side; Trade repository expands
the view of OTCD Rates from 3 basic to 12 detailed product categories
500 480
OTCD Rates 2% Product Breakdowns
9% 3%
Notional Outstanding 12% 4% ▲ There
are no surprises on the
By Product Type ETD side other than the growth
6% OTCD Rates Detail
US$ Trillions

300 N ti
Notional l Outstanding
O t t di in proportion of options relative
10% By Product Type to futures. Outside of equities,
options on futures (OOF) are not
200 79% known for wide adoption, which
is an indication of forthe
14% 12%
100 growth of options
g p relative to
78% futures.
- X-Currency Exotic Swap ▲ The main takeaways from the
2002 2004 2006 2008 2010e ▲ The mainoftakeaways
analysis product types fromcomes
Exotic Option analysis
(All) Swaps Forwards (FRAs) (All) Options from the of product
OTCD side:types comes
It can now
Debt Option from the OTCD side, with
be seen that the historical catch- the
80 Inflation Swap
all category catch-all
catch all category
for swaps used for
71 swaps used by BIS, actually an
ETD Rates BIS is actually an amalgamation
Exotic Swap amalgamation of at least 7 sub-
Notional Open Interest of at least 7 sub-categories.
60 By Product Type X-Currency Swap categories. The same
Same with options, nowisknown
true for
62% options, now known to consist of
US$ Trilliions

50 Cap/Floor (Options) to consist of 4 product

69% 4 product categories.
categories. (ForwardsForwards
– or
40 Basis Swap are the only homogeneous
FRAs) – are the only
Swaption category.
homogeneous category through
history. Furthermore, there is
Ovrnght Indxd Swap (OIS) ▲ There is now a clearer indication
20 now a clearer indication of the
54% Forwards (FRAs) of the level of standardized
10 31% e e o
level of sstandardized
a da d ed e exposures,
posu es,
exposures, which hi h are att lleastt
46% (Vanilla) Swap which are at least 94% of the
- 94% of the Rates segment (i.e.,
Rates segment (i.e. – the first 5
2002 2004 2006 2008 2010e 1-Oct-10 the first 5 categories).
Source: BIS, WFE, TriOptima, TABB Group Futures Options
TABB Group The Global Risk Transfer Market | Nov 2010 63
Regional breakdowns for Rates are unique relative to their respective
segments of the GRTM; Less concentration in APAC overall
ETD – Short Term Rates Regional Breakdowns
Notional Turnover - 2009
▲ A consistent theme of this analysis is that both ETD and OTCD
Americas, exposures are over-weighted to the West relative to the distribution
51% of economic activityy around the world.
▲ With at least 32% of global GDP in 2009, TABB Group expects
APAC derivative markets to grow significantly in the future. The
main argument against this expectation is whether risk transfer in
EMEA, 47% APAC-centric interest rate derivatives is being conducted in other
regions, thereby decoupling risk transfer from geography. Though
likely, it should be combated by APAC dealers and exchanges.
▲ Of all the recent gains in transparency in OTCD exposures, regional
activity remains among the least transparent.
APAC, 2%
ETD – Long Term Rates OTCD
N i
lTTurnover - 2009 N i
lTTurnover – 2010e
APAC, 26%
Americas, APAC, 9%

EMEA, 32%

EMEA, 65%

Source: BIS, WFE, TABB Group

TABB Group The Global Risk Transfer Market | Nov 2010 64
Currency distribution in OTC Rates instruments is dominated by US dollar and
Euro exposures, accounting for 33% and 40%, respectively for 2010; Trading
in Rates instruments occurs in 79 currencies around the globe
OTCD Rates - Currency Distribution Currency Breakdown
All OTCD Rates Products – Notional Turnover
▲ Currency distribution within OTC interest
rate derivatives has been relatively stable
3% 3% 4% 6% 5% since 1998, with the combination of US
4% dollar and Euro denominated trades
8% 9%
6% 10% 10% fluctuating between 71% (2007) and 79%
6% 5% (2004) over the 12-year
12 year period.
10% 6% ▲ Notable growth has been found in Pound
▲ Notable growth has been found in Pound
sterling and “Other” currencies, while
sterling g and “Other” currencies,, while
t bl d declines
li h
have b been ffoundd iin
notable declines have been found in
Japanese yen and Swiss franc.
45% Japanese yen and Swiss franc.
47% 40% ▲ OTC interest rate derivatives now come
39% ▲ OTC
46% in 79 interest
currencies.rate SwapClear,
derivative trades are
the leading
Rates CCP, done in 79 currencies.
supports clearing of 14
currencies supports
currencies. The remaining clearing of 20
currencies. The remaining
occur in bilateral transactions betweencurrencies
what in bilateral
Trioptima transactions between
trade repository labels
what the TriOptima trade
“G14 dealers” and “non-G14 dealers”. repository labels
34% 32% 33% “G14 dealers”
▲ Among and “non-G14
the up-and-coming dealers”.
▲ within OTC interest
The Mexican rate derivatives,
peso, Korean won, andthe
Indian rupeepeso, areKorean
beginning won,toand
rupee are notable for their
volumes in interest rate derivatives trade volumes;
1998 2001 2004 2007 2010e numbering in the 10’s of thousands.
trade volumes numbering in the 10’s of
▲ Of particular note, the Chinese yuan – the
US dollar Euro * Japanese yen currency of the 2nd largest economy in
Pound sterling Swiss franc Canadian dollar ▲ The Chinese
the world yuan24
orld – ranks – ththe
at currency of the
$200 billion
Australian dollar Swedish krona Other 2 nd largest economy in the world – ranks
notional (below the Czech koruna and
24 th at $200 billion notional (below the
Hungarian forint).
* Includes predecessors for 1998 Czech koruna and Hungarian forint).
Source: BIS, TriOptima
TABB Group The Global Risk Transfer Market | Nov 2010 65
Detailed Analysis:
Credit Default Swaps

TABB Group The Global Risk Transfer Market | Nov 2010 66

CDS usage, measured by outstanding notional, has leveled out following its
two-year decline from the peak in late 2007; Slight growth expected in 2010
CDS Total Outstanding Notional
60 OTC Credit Derivatives
 Outstanding notional grew to nearly $60 trillion at
Notional Outstanding
its 2007 peak. Major drivers for growth include
lowering capital requirements, hedge against
50 mortgage
t bonds,
b d and d as lleverage tto create
synthetic CDOs.
 CDS began its slide in early 2008. Trade
compression efforts drove the majority of the drop.
40  Although the market will see transaction volumes
grow following the full implementation of Dodd-
US$ Trillions

Frank; the outstanding notional will grow only

slightly as trade compression is now part of the
status quo.
41% Exchange-Traded Equivalent
No di
N directt comparison
i exists
i t ffor CDS in
i ETD.

20  Eurex lists futures on the iTraxx index, but as of
September 2010 there was zero open interest.
 As centrally cleared CDS begin to grow, it is more
likely the market will see a move to cleared swaps
10 54%
traded on SEFs rather than moves to CDS futures
Market Participants
-  Financial firms still account for the majority of CDS
holdings, with “reporting dealers” accounting for
54% of the outstanding notional in 2010.
Reporting dealers (net)  Usage by non-financial firms has grown to 5% from
Other financial institutions below 1% in 2004 driven largely by efforts to
Non-financial institutions standardize CDS contracts and the trading
Source: BIS, DTCC, TABB Group lifecycle.
TABB Group The Global Risk Transfer Market | Nov 2010 67
The credit crisis deflated a bubble in CDS holdings by special purpose
vehicles that peaked in 2007

SPV CDS Holdings – Outstanding Notional

 Special Purpose Vehicles (SPVs), also referred to as Special Purpose Entities (SPEs), are legal entities set up for a sole purpose;
as it relates to this study. SPVs are used to hold the assets associated with Asset Backed Securities, Collateralized Debt
g and other like structured p
 Leading up to the credit crisis, instead of actual mortgage bonds, SPVs would hold CDS on underlying mortgage bonds to create a
“synthetic” CDO, since the CDS provided similar, yet leveraged, exposure to the underlying mortgage pool.
 As the credit crisis caused the creation of these structured products to effectively cease and many existing SPVs to unwind, SPV
CDS holdings dropped off dramatically from their height in 2007 to the end of 2009.
 The low CAGR from 2005-2009 compared to the sharp growth and decline that occurred in the same period clearly defines the
CDO bubble.

10,000 OTC Credit Derivatives

Holdings by SPVs
US$ Billions



4y CAGR 5%

2,559 3,696 5,639 8,460 10,778 9,216 4,608 3,888 3,119

2005-H2 2006-H1 2006-H2 2007-H1 2007-H2 2008-H1 2008-H2 2009-H1 2009-H2
Source: BIS
TABB Group The Global Risk Transfer Market | Nov 2010 68
Single-name CDS contracts account for the majority of all CDSs, taking back
ground from index contracts, which once approached nearly half of all
outstanding notional
Multi-Name / Index CDS
OTC Credit Derivatives  Index CDS are based on the performance of an
Product Distribution underlying basket of credits.
 The most popular “families” of index CDS include the
50 CDX indices (US) and iTraxx indices (Europe). Both
cases included a variety of corporate debt grouped as
Investment Grade, High Yield, etc. Index components
44% 42%
tend to be the most liquid single-name CDS contracts.
40  Index CDS provide credit protection against the
US$ Trillions

broader debt market as opposed to a single issue

(similar to using S&P 500 futures, for example).
39%  Index products were the first CDS contracts to move
to a CCP.
30 33%
33% Single-Name CDS
 The original CDS approach, single-name CDS are
38% contracts with a single issue as the reference entity.
20  Single-name CDS provide a way to either hedge or
32% invest against a particular debt issuance.
58% 61%  One of the major drivers behind the creation of the
25% 56% 67% single-name CDS contract was to create a synthetic
57% 67%
10 62% method for shorting bonds. Shorting bonds is difficult
20% 68% and expensive without CDS.
72%  At their peak, index CDS accounted for 44% of the
80% outstanding notional for all credit derivatives, but
- following standardization of contract terms,
terms central
2004 2005 2006 2007 2008 2009 clearing of single-name CDSs, and a drive to fine-tune
risk models in all financial firms, single-name CDSs
Single-Name Multi-Name / Index
Source: BIS now account for over 67% of the outstanding notional.
TABB Group The Global Risk Transfer Market | Nov 2010 69
Single-name CDSs, arguably the most complex product to be centrally cleared
safely, are becoming increasingly popular at ICE Trust US and ICE Clear
200 ICE Trust US 25 ICE CDS Clearing - Global Notional Outstanding
by Product Type

Single-Name CDSs
175 Euro Index
20 13%

125 Euro Single

US$ Billio

15 US Single
100 22%
75 10
50 US Index
5 31%
25 Total: $928 billion
- - (August 2010)

Single-Name CDS Overview

25 Single CDS are difficult to clear todue to low
ICE Clear Europe  Single-name CDS are complex clear dueliquidity and
to low liquidity and

Single Name CDSs complex pricing models.
models Since single-name
single means
Low liquidity name CDSs trade
daily pricing

250 20 infrequently, marginmust
needed for margin mustbe bedone
calculated via marking-to-model,
via mark-to-model process.
US$ Billions

with assumptions
Models must then on default
predict howlikelihood incorporated.
likely a credit event is.Despite
200 15 continuous modeling of default scenarios, it is unclear how
scenarios of reference entities
and clearing
if existingmembers,
single CDS it isclearing
how and mutualize risk
if existing as
150 effectivelyy asg assumed.
CDS clearing models mutualize risk as effectivelyy as believed.
100 Single-Name Central Clearing
50  Open interest for single CDSs has grown more quickly in the
US than Europe as new legislation
US is set and
- - regulationsan
Assuming are
rate of 1.3, average
Assuming trade
an FX
in the
of 1.3,
US and
Europe trade
size at
in nearly
the US$8
- 9Europe
million are
per similar
trade. atThenearly
– 9 million
in single-name
/ trade. The
in single
is a result
their falls
Open Interest Transactions in
line with popularity
their increasing
over index
CDS.over index CDSs as
Source: ICE, TABB Group discussed earlier.
TABB Group The Global Risk Transfer Market | October 2010 70
CDS contracts that reference corporate debt account for the majority of
outstanding notional with over 80% held in Europe and the Americas

Top 1000 Reference Entities - Net Notional Top 1000 Reference Entities - Net Notional
by Type by Country
LCDS Japan Asia Ex-
1% RMBS 3% Japan
1% 3% Australia
Other State Body
Sovereign 1% NZ
8% Other 2%
17% 10%

41% Europe

Total New Contracts - Quarterly

 CDS usage is primarily focused around the hedging and investing against corporate debt. Corporate debt accounts for nearly
three-quarters of the outstanding notional among the top 1000 reference entities.
 Sovereign debt has also become a focal point for CDS traders following the European debt crisis that came to a head in the spring
of 2010.
 CDS contracts exposed to risks in Europe and the Americas account for over 80% of the top 1000 contracts. This is among the
main reasons why the global focus on OTCD reform has been placed at the feet of US and EU legislation and regulation.
Source: DTCC
TABB Group The Global Risk Transfer Market | Nov 2010 71
Total turnover of CDSs is up since early 2009, although net notional change
has been negative
Change - Total Number of Contracts CDS Trading Volume
 The net change in number of open
75 contracts from January
Jan-20092009 to Sept-
50 September
p was nearly
2010 y 187,000.
was, upp nearly
They net

62 187,000.in The
change notional
net change
in notional
25 56
42 outstanding
the same period,
the same wasperiod
- howeverofwas
decline $3.4down
$3.4 trillion.
(3) (29)
(25) (63) 

Trade compression
compression efforts,
efforts, netting
via clearinghouses,
clearinghouses and the entrance
and the
(50) via clearinghouses, entrance
Sum of changes = 186.900 contracts of more
more short
short term
term traders
traders are
are driving
(75) volumes up while keeping notional
volumes up while notional levels
levels in decline.
continue to decline.
 Average trade size has remained
 Average
steadyg attrade
1 000
1,000 steadyhowever
at roughly $24 Group
million sees
per a
Change - Total Notional Outstanding trade, TABB
trade. TABB Group sees a
shift towards smaller trade sizes asshift
500 814 towards
the movesmaller
towards trade sizes as the
an electronically

activity moves
traded, toward an world
- electronically-traded
begins. and centrally-
(140) cleared
l d environment.
i t

(638) (801)  Furthermore, the growth in the third

(1,332)  quarter of
Growth 2010 signals
in 2010:Q3 the the
signals market’s
perception of some regulatory
market’s perception of some
(1,000) (1,930)
certaintythe passage
following theof the
Sum of changes = $(3.42) trillion Dodd-Frank ActDodd Frank ActEU’s
in the
passage of the Dodd-Frank US, the in the
(1 500)
(1,500) proposed framework, and progress
US, the EU’s proposed framework,
by US
and regulators
progress in the
by US rule writing
regulators in the
(2,000) process.
rule-writing process.
Source: DTCC
TABB Group The Global Risk Transfer Market | Nov 2010 72
The number of new contracts created quarterly has grown, while average
trade size has remained consistent

80 Total New Contracts - Quarterly

Average Weekly CDS Trades

By Quarter  The writing of new CDS trades has

60 begun to accelerate after stagnating
g the credit crisis.

40  The launch of ICE Clear US in 2009

coupled with a move towards
20 standardization of contracts and credit
event management has driven growth.

-  Net contract volume has experienced

periodic quarterly declines although this
can be attributed to trade compression.
Total New Contracts - Weekly
Average Weekly CDS Trades
 The weekly
Th kl view
i shows
h considerably
id bl
and Average Trade Size more volatility in contract creation and
120 By Week 50

$ Millions
average trade size throughout the period.
100 40
80  Credit events and macroeconomic data
(such as the European debt crisis in the


20 spring of 2010) have had measurable
40 impacts on the CDS market.
20 10
 Recently, average trade size is trending
- -
slightly below the 2009-2010 average of
$26 million
illi per contract,
t t but
b t average
trade size has remained remarkably
consistent over the past 18-22 months.
Source: DTCC
New Trade Avg Trade Size Linear (Avg Trade Size)

TABB Group The Global Risk Transfer Market | Nov 2010 73

Detailed Analysis:
Other Major Asset Classes

TABB Group The Global Risk Transfer Market | Nov 2010 74

The limits of the ETD structure is illustrated by strong demand for OTC equity

Equity Derivatives Comparison Drivers for OTC equity derivatives

Notional Outstanding / Open Interest
 Despite the fact that the cash market is
15.0 exchange-traded and that most global markets
14.0 have vibrant equity
q y ETD markets, there is still
significant usage of OTC equity derivatives,
 In some markets, such as London, the drivers for
the use of OTCD instruments are related to tax
1.3 considerations.
 Equity swaps are also widely used to access
S$ Trillions

1.1 emerging markets, where owning the underlying

shares can be restricted and / or come with
7.5 significant post-trade clearing and settlement

5.3  In the US, many institutional investors choose to

5.0 trade look-a-like contracts that have all the same
4.1 parameters as an ETD option, but are traded
0.6 and cleared on a bilateral basis. TABB Group
believes that these contracts will become
2.5 centrally-cleared under the new regulations.
 Exchanges have tried to launch many features of
4.4 8.5 7.0 the OTC options market with such products as
- binaries, knockouts and barriers, with limited
2004 2005 2006 2007 2008 2009 2010e success Lack of liquidity
success. liquidity, the need to keep
strategies anonymous and dealer efforts to
OTCD ETD Ratio OTCD / ETD provide attractive product sets have limited their
appeal to investors.
Source: BIS, WFE, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 75
OTCDs and ETDs for equities exhibit the most similar behavior relative all
other asset classes

Drivers ofTurnover
Frequencyin in
Equity Markets
Equity Markets ETD - Equity
▲ A substantial portion of the equity OTCD market is similar in structure to the ETD
market. As a result, the skew caused by short-term expirations is not as prevalent here
as in other OTCD asset classes, p particularly
y interest rate derivatives.

▲ Contracts-for-Differences and Total Return Swaps have higher turnover levels since
they are used as a substitute for cash instruments. These products are designed to be
liquid and cost-effective for investors.

▲ Long term hedging products,

products such as dividend swaps and knockouts,
knockouts have much lower
turnover ratios than other equity OTCDs. These types of instruments provide cost-
effective strategies to reduce risk, particularly against specific “Black Swan” events.

OTCD - Equity
N ti lOOutstanding
t t di / Open
O Interest
I t t 30
Notional Turnover / Volume 109
Turnover Frequency 24
US$ Trillions


10 10 9

8 7 5

2004 2005 2006 2007 2008 2009 2010e 2004 2005 2006 2007 2008 2009 2010e

Source: BIS, WFE, TABB Group

TABB Group The Global Risk Transfer Market | Nov 2010 76
The FX market has traditionally been dominated by OTCDs, though adoption
of ETDs has been rising in recent years

OTCD FX – Notional Turnover Drivers of FX Derivatives

(includes Spot transactions) 1,274
1,400  The FX market is dominated by non-
1,200 1,079 US entities looking to hedge
23% exposure
p to US dollar-denominated
US$ Trillion

1 000
1,000 23% assets.
800  The prices of many US dollar-
600 23% 57% denominated assets are correlated
400 to the value of the US dollar. FX
54% forwards pprovide an effective way
y to
20% 20% hedge this exposure.
 Although more than three-quarters
2004 2005 2006 2007 2008 2009 2010e
of OTCDs in FX occur outside the
Dashed points are interpolated estimates US, 42% of OTCD turnover is in US
dollar-related instruments.
ETD FX – Notional Turnover 4%  Outside the US, FX spot market
40 transactions are popular with the
22% retail sector, who hedge their own
US$ Trilllions

9% 3% currencies against the cost of

4% 15% imported items.
20  Currency swaps are well-suited to
migrate to a CCP model, since they
10 are highly standardized instruments
97% 98% 99% 98% 87% 82% 75% that share many of the
- characteristics of IR swaps
swaps. The
2004 2005 2006 2007 2008 2009 2010e high concentration of short-term
Americas EMEA APAC maturities, however, tends to lower
the urgency here.
Source: BIS, WFE, ISDA, TABB Group

TABB Group The Global Risk Transfer Market | Nov 2010 77

The TOF of the FX market highlights its bias to short-term trades; Impacts of
regulatory reform, the globe-shifting economic landscape, and APAC currency
policies all warrant close monitoring
Maturity Distribution Drivers of OTC FX derivatives
All OTCD FX Products – Notional Outstanding
6% 6% 7%
 The unique nature of the FX market –
7% 7% 7% 8% 13% 9%
12% 14%
18% liquid, US dollar–focused, but with most
15% 16% 15% 17% 17%
15% 21% activityy occurringg outside the US - makes
20% it difficult to determine potential regulatory
 Most of the hedging activity in the FX
82% 80% 79% 77% 78% 76% 75% market is relatively short-term in duration.
72% 70%
 The small exchange-traded
exchange traded FX
derivatives market turns over more than
80 times per year.
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009  Shifts in regulatory requirements could
< 1 year 1 - 5 years > 5 years potentially have a dramatic impact on FX
ETD, particularly as the world enters a
OTCD - FX period of trade wars and currency
US$ Trrillions

OTC FX Swaps
Turnover Maturity Breakdown
11.2 10.4 74%

2004 200
2005 2006 200
2007 2008 2009 2010
Notional Outstanding / Open Interest 1%
Notional Turnover / Volume
Turnover Frequency < 7 days 7 days - 1 yr > 1 year
Source: BIS, WFE, TABB Group
TABB Group The Global Risk Transfer Market | Nov 2010 78
Similar to Rates, comparing the TOF of OTCDs and ETDs for commodities
yields questions about structural versus strategic motivations; Currently,
detailed information about OTC commodity derivatives is elusive
OTCD - Commodity Few near-term changes
45 42
▲ The low utilization of OTC
US$ Trillions

commodities suggests that most

needs are being g met in the ETD side
30 of the market. Therefore, OTCDs for
25 commodities would be most useful
20 17 for exotic structures, rare size issues,
15 and precision maturities.
0 5.0
0 5.0
0 ▲ Indeed,
Indeed many of the ETD markets
5 were created to help the end users
- (such as farmers and oil well drillers)
2004 2005 2006 2007 2008 2009 2010e to hedge against macroeconomic
impacts of asset prices.
ETD - Commodity
45 41
▲ Thus, part of the turnover frequency
is seasonal as certain products are
$ Trillions

29 ready to be delivered to the market

30 and no longer need to be hedged.
20 91 2
91.2 ▲ Thus,
Thus the disparity in turnover

15 frequency between OTCDs and

10 43.1 ETDs in this asset class is among the
5 0.4 highest.
2004 2005 2006 2007 2008 2009 2010e ▲ Given current regulatory uncertainty,
TABB Group does not believe there
Notional Outstanding / Open Interest will be much of this market segment
Notional Turnover / Volume that initially move to be centrally
Source: BIS, WFE, TABB Group Turnover Frequency cleared.
TABB Group The Global Risk Transfer Market | Nov 2010 79
New York
+ 1.646.722.7800
Westborough, MA
+ 1.508.836.2031
1 508 836 2031
+ 44 (0) 203 207 9397

E. Paul Rowady, Jr.

Senior Analyst

V08:030 | November 2010 | www.tabbgroup.com

TABB Group Credit Default Swaps: Industry Projections | March 2009 80