Regulations will have a significant impact on how SEF aggregators function and how widely these aggregators will be adopted by various market participants. Some of the most contentious rule proposals are those that will have the greatest impact on liquidity fragmentation. They include the 15-second rule, the ability to voice trade, the “block trade” definition, best execution requirements, and the requirement to send an RFQ to five dealers. The Smart Automated Agency Broker (SAAB), think swaps smart order router on steroids, will not only help traders execute the right product at the right price, but it will also mitigate regulatory complexities.
Much of the complexity has to do with the regulators’ goal of increasing transparency in the market. The thing we have to remember is, market participants are hypocritical when it comes to transparency: They want to get transparency, but don’t want to give it in return. While regulators work to pass rules that increase pre-trade and post-trade reporting, the market will push to ensure simultaneous regulatory compliance and trading anonymity via smart and flexible technology.
The Rules of Engagement
There are those at the CFTC who dislike voice trading on a SEF because they believe it limits the market’s ability to see all available bids and offers on the screen in real time. Because most swaps products are fraught with complexities and trade with relative infrequency, however, being able to speak to a broker directly about market pricing remains a necessity.
By way of compromising with the industry the CFTC has instituted what has come to be known as the “15-second rule.” It states that two parties may prearrange an order over the phone, but the order must then be displayed on the open market for 15 seconds. This communicates to the market the intentions of both the buyer and seller, which then creates an easy opportunity to trade ahead of the order. The 15-second rule also allows other market participants to price improve the original arrangement which, in theory, could benefit the buyer.
What does this have to do with liquidity fragmentation? The information leakage created by displaying a prearranged order to the market for 15 seconds is like a football coach giving his playbook to the opposing team a week before the big game. To prevent counterparties from being taken advantage of, large orders will need to be sliced and diced then sprayed across the relevant SEFs-something only a SAAB could do effectively. A firm having to protect its information in this way accounts for much of the swaps market’s expected increase in transaction volume. The percentage of transaction volume that the 15-second rule will impact will largely be determined by the proposed block trade rules.
Both the CFTC and SEC have proposed rules that define the size of a block trade, and allow block trades to be reported to the market after 15 minutes (rather than “as soon as technologically possible”). Treating a block trade differently than smaller orders is common in regulated markets. What’s of concern to us isn’t that block trades exist, but how they are defined.
The swaps market is a block-trade market by definition (the average interest rate swap is $129 million). The recent CFTC block trade rule defines roughly one third of the market as block trades (the details of this rule are explained well in another TabbFORUM post). Conversations with various market participants have left me to believe that the current rule is much more reasonable than the original proposal which would have seen only 5% of the market defined as a block. However, assuming that an interest rate swap block trade will be roughly $250 million or higher, a large swath of traders concerned with execution anonymity that routinely trade IRS sized between $100-200 million will quickly realize the only way to do that size without create a market stir is via a SAAB.
The 5 RFQ requirement and order interaction rules will not cause fragmented markets, but they will impact how the SAAB functions. The CFTC’s “5 RFQ” rule requires that all RFQs be sent to at least five different liquidity providers. The SEC has countered with a proposal that RFQs must be sent to “one or more” liquidity providers. TABB Group believes the CFTC will lower the number of liquidity providers that must be contacted from five to two. Still, the SAAB would need to know the relevant regulator for each product and act accordingly. This is most critical for credit traders, as index CDSs fall under the CFTC’s rules, and single-name CDSs, the SEC’s.
SEF best execution rules, more formally known as order interaction rules, will require SEFs to force interaction between their RFQs and CLOBs. Before a RFQ can be acted upon, for example, any better-priced liquidity in the order book would need to be taken out. The SEC has proposed such rules and the CFTC continues to contemplate a similar approach. TABB Group believes this rule is unnecessary. Market participants all have a fiduciary responsibility, whether to their investors, shareholders or brokerage clients, to execute in the most efficient way possible. Furthermore, whether mandated or not, SAABs will take into account all market prices when determining where to trade, regardless of market model. It’s like mandating that we drink coffee in the morning: It’s going to happen anyway, so why bother mandating it?
As a side note, technology can and will help market participants deal with these differences between SEC and CFTC rules; technology might also provide opportunities for those looking to benefit from the rule differences. But this begs the question: If the industry will simply work around the rule differences anyway, wouldn’t it be easier on everyone if there were no rule differences?
Don’t Tell Anyone I’m Here
Buy-side traders will also look to minimize the market impact of their trading in other ways. Sponsored access, as it is known in equity markets, is when a broker allows a client to trade directly on an exchange using the broker’s exchange membership. The broker is still responsible for the orders that go down to the exchange, and so must have pre-trade risk procedures in place, but the client can self-direct trades without any manual interaction from the broker.
CFTC rules allow direct access to SEFs without any broker involvement, but this direct access is only part of the allure of sponsored access in equities markets. Sponsored access also allows the client to trade under cover of the broker’s name, which leaves the market unaware of who is actually doing the trade. This “service,” if it is offered for swaps trading, could be a boon for dealers because it would encourage even large hedge funds to trade through a broker rather than accessing the market directly. The success of swaps sponsored access is inversely proportional to the success of SEFs that offer anonymous trading, because the latter would severely limit the need for the former.
Even if sponsored access becomes common, brokers would still not be able to execute a trade on a SEF and then move that position to their clients’ accounts (commonly referred to as the Principal-Principal model). “Moving” the original trade would be a trade in and of itself. This second trade would then fall under trading mandates, which means that the trade would have to be exposed to the SEF (via the 15-second rule) before it could be executed. That, of course, would generate additional risk and cost to both the client and dealer, making the approach less than desirable.
Direct market access for clients also provides further support for the agency model, and its use of the SAAB. Since brokers cannot profit by taking principal risk, they will instead charge fees for use of their trading tools and physical market access. TABB Group believes the market will ultimately adopt this model. This also brings us to the single dealer portal (SDP).
SDP to SAAB
Under proposed regulations, dealers will not be able to fully own and operate SEFs. This means that SDPs, those that now act as primary sources of liquidity for the buy side, cannot register as SEFs unless owning dealers were to sell off most of their businesses. Therefore, many SDPs are in the process of converting their swap-trading screens to SEF aggregators and SAABs (see Exhibit 1). These conversions are most prevalent among fixed-income platforms focused on CDS and interest rate swaps trading. TABB Group has also seen evidence that platforms that are currently focused on other areas, such as spot FX or US Treasuries, plan to build SEF aggregators to build up rather than dismantle their SDPs. By providing their clients with these new liquidity-seeking tools, dealers can try to maintain the screen real estate and relationships they have spent years establishing, even though those clients will be able to trade directly on SEFs themselves.
This all sounds like a win-win, doesn’t it? Clients get trading tools to reduce the complexity of execution at virtually no extra cost, and dealers can still utilize the SDPs in which they have invested so much. Unfortunately, it might not be that easy. A number of questions still linger as to the regulatory requirements and mechanics of dealers offering such a toolset.
Regulators are working to determine if they should require SEF aggregators to comply with the same kinds of rules with which SEFs must comply. If SEF aggregators provide clients with pre-trade price transparency-one of the core goals of Dodd-Frank-ensuring they do that fairly and consistently is critically important. Based on TABB Group’s conversations with regulators, this additional regulatory burden seems unlikely because nearly everything SEFs do will already be heavily regulated. Besides, several other markets, including equities, futures, options and FX have liquidity aggregators and, to date, regulators haven’t put further oversight in place on any of them.
This post was taken in large part from my research report “Swaps Liquidity Aggregation: Best Execution to Product Selection”
Wow – it really has been a year. Even more amazing is that Bear, Lehman and the rest were almost three years ago. Things have changed. I’d argue even as early as 2009 the swaps markets were more transparent than ever before. The bottom line today is the rules are coming and everyone knows it (even if they won’t admit it) and because of that the move to more automation is already happening.
“There certainly have been shifts in approach and strategy for a lot of people,” said Kevin McPartland, a [principal] in New York with Tabb Group, a financial markets research and advisory company.
Even as regulators rush to finish rules governing swaps, there has been a “slight uptick” in electronic trading to make sure the system works when regulations are ready, he said.
Dodd-Frank talks about the swaps market as a whole – meaning all swaps. Sure, it breaks out securities based swaps and a few others, but the intention seemed to be that they wanted all swaps regulated. But as I much as I’m for the idea of not creating loopholes – intentionally or otherwise – its really hard to lump FX swaps in the same bucket as CDS and even IR swaps. Its just a different product with a different use, not to mention a product that sees the transfer of concrete assets – namely currency.
But all of that aside, its just too politically complicated to regulate FX. Countries (and Unions for that matter) are proud of – and control – there own currency. Putting specific regulations non those transaction in the US only might annoy not just traders but other central banks. It is possible that even though FX swaps had nothing to do with the world’s issues in 2008 they could have something to do with the next crisis, but it certainly seems unlikely. My comments in the FT on the topic:
“There are a lot of geo-political issues involved in the US trying to regulate currency trading,” said Kevin McPartland, senior analyst at Tabb Group. “In the end that’s what will lead Washington to exempt currencies as an entire asset class from their regulatory push.”
Credit Default Swaps (CDS) are so 2005.
My new favorite derivative is the contingent convertible bond – better known as the CoCo. CoCos work like traditional convertible bonds in that the buyer buys a bond that can be converted to equity at an agreed upon price. The difference is that CoCo bonds are automatically converted to equity when the net equity of the issuing bank falls below an acceptable floor. The floor value is set by the issuer, but in reality it is designed to mimic banking requirements set by international and/or local regulators. Think of the former as an option and the latter as a stop limit.
It’s not the structure of the CoCo that puts the product in the structured derivative hall of fame next to the CDS and the CDO, however. The CoCos’ intrigue lies in the fact that regulators allow banks to count these instruments toward their Tier-1 capital. Basel III will raise these minimums over the next decade and local legislation in key markets will likely set rates even higher, making capital ratios a key area of focus for the bank; hence the resurgence of the CoCo.
As the thinking goes, if a bank with outstanding CoCos has a capital shock in which its Tier-1 capital falls below the regulatory minimum set by the Basel committee or other regulator, the CoCos will automatically convert to equity from debt, magically injecting capital into the firm while simultaneously reducing its debt load.
If things get really bad again, the banks are hedged. No government bailouts, no too big too fail, no complaining tax payers. Unfortunately, we shouldn’t take anything at face value anymore and the concept of a perfect hedge is pure fiction. Furthermore, when regulators think a single financial instrument can create a quick fix, it’s akin to a dieter thinking he or she can take a pill, eat lettuce for a week and suddenly be in shape for the rest of his or her life.
Ironically we saw a similar situation with Basel II in the early part of the last decade. Banks needed more capital and they figured out they could improve their capital ratio by using CDSs to flatten out bond positions synthetically. Regulators quickly caught on to this idea and allowed the practice, the derivatives markets were around the same time deregulated and yada, yada, yada, 2008.
The CDS theory for reducing debt exposure was accurate – just like the CoCos theory of today. CDS do, in fact, act as a great hedging tool (and yes, as a speculation tool as well). It is certainly true that counterparty risk was mostly ignored back then, but that lack of foresight aside, the product performed as advertised. The problem, as I just stated, was that banks and regulators treated it as the solution rather than a tool in the arsenal. Similarly, CoCos are a great risk management tool for banks (not to mention they pay the borrower interest rates similar to that of riskier junk bonds), but they are not a magic pill.
Let’s paint the picture for the CoCos financial collapse. In 2014, Bank XYZ gets in trouble because of huge municipal bond defaults in the US (assuming of course Meredith Whitney is right). Capital levels at Bank XYZ get low enough to trigger the CoCos, flooding the market with liquidity in stock for XYZ. Since the equity market saw the problems coming for XYZ, short sellers already had the price of the stock down 60% from its 52 week high. The sudden flood of shares into market drives the price of the stock down to 90% below the high. So now although XYZ has less debt outstanding in return for more shares outstanding, the downward spiral in the equity market has actually left the bank less capitalized than it was before the CoCos run began. This says nothing of the mess created by the CoCos hedges gone wrong – long term equity puts, for example. Multiply this by several banks and hedge funds trading CoCos derivatives (CDS on CDO of CoCos anyone?), we have a real problem.
This level of pessimism is uncharacteristic of my generally free market, derivatives are innovative thinking. Maybe I’m reading too many anti-Wall Street books or maybe I’ve been on the Street long enough to see history repeating itself. Whatever the reason, the near-definite surge in CoCos issuance must be watched.
Time to create the first CEF – CoCo Execution Facility?
Many still seem skeptical of credit default swaps (CDS), but the reality is (and always has been) that they play an important benchmarking function for the global credit markets. That’s why when I heard that GM CDS was trading without the existing of any underlying GM bond I wasn’t at all surprised.
Two things to keep in mind. First, CDS pricing is always done via models that look at the characteristics of the bond (maturity, interest rate, etc.) and the probability of default (which is determined using formulas, but is essentially an educated guess based on the health of the underlying company). So in this case, despite the lack of any real underlying bond, traders can make some assumptions about the former and have plenty of information on the latter.
Secondly, CDS generally is cash settled. This practice was taken up years ago to prevent a supply/demand imbalance for the underlying bond when delivery is required. Therefore, the lack of an underlying GM bond doesn’t really matter.
My quote from the paper:
“Sure, having CDS without debt looks odd, and people may balk because credit derivatives were at the center of the AIG collapse, but that doesn’t change the fact that CDS prices are the de facto benchmark used to measure the state of the credit market,” said Kevin McPartland, senior analyst at research firm TABB Group.
Is the sport called soccer or football? Should swaps be traded on Swap Execution Facilities (SEF) or Organized Trading Facilities (OTF)? For that matter, should organized be spelled with a ‘z’ or an ‘s’? While some of these debates are as old as the U.S. Declaration of Independence and others brand new, they highlight differences between how Europeans and Americans approach the rules. The real question however, is do these differences matter?
The G20 agreed that regulated trading venues are good, and we should push as much of the over-the-counter derivatives market on to those platforms as possible. Not just traditional exchanges but essentially any trading platform (preferably an electronic one) regulated by the local regulatory authority. The U.S. put its money where its mouth is and included in the Dodd-Frank Act language that requires exactly that: “With respect to transactions involving swaps subject to the clearing requirement … counterparties shall … execute the transaction on a board of trade designated as a contract market … or … execute the transaction on a swap execution facility…”
Interestingly, the European Commission’s (EC) proposal on OTC derivatives lacked the so-called trading requirement. Anything that can be cleared must be cleared; all OTC derivative transactions must be reported. Trading, it seemed, was not viewed in Europe as important to reducing systemic risk. The greatest fear of major U.S. banks apparently had come true even after their months of lobbying – with U.S. laws much more stringent than those in Europe, swaps trading was leaving for London and we’d all have to go with it or find another line of work.
Enter the MiFID Review. Remember the original MiFID? The Markets in Financial Instruments Directive is what allowed new trading venues, called multi-lateral trading facilities (MTF), to pop up all over Europe and wrestle market share away from the incumbent equity exchanges. The likes of BATS, Chi-X and other new pan-European venues ultimately drove the once dominant LSE into a marriage with the Toronto-based TMX Group and encouraged Deutsche Börse and NYSE Euronext to merge.
A review of MiFID was always planned for a few years after the initial implementation. Furthermore, MiFID was always intended to cover much more than the equity market – hence the “Financial Instruments” in the title. But it goes without saying a lot has changed since MiFID was first approved in 2007 and the result is a much shorter timeline and a proposal that brings about more sweeping front-to-back reform across a much broader list of asset classes including, of course, the trading of OTC derivatives.
So it turns out that Europe will likely have a swaps trading requirement after all. More precisely: “the MiFID framework directive could be amended to require all trading in derivatives which are eligible for clearing and sufficiently liquid to move either to regulated markets, MTFs, or a specific sub-regime of organised trading facilities…”
With that statement we see that the U.S. and Europe are going down similar paths. But as with all things as complex as the swaps market, different – albeit equally intelligent – people will undoubtedly find different solutions to the same problem. That takes us back to my original question: Do these differences matter?
How to trade
U.S. regulators have come to agree that dictating the exact method by which swaps must be traded on a SEF is not a good idea. A lightly disseminated draft proposal from the Commodity Futures Trading Commission included a requirement that the most liquid swaps contracts needed to trade in a central limit order book – an attempt to mimic the current approach used for exchanged-traded products everywhere in the world. Thankfully this requirement was removed from the official release a week later.
The International Organization of Securities Commissions (IOSCO) recently published its views on how the use of regulated traded platforms will impact the swaps market and their findings matched the decision made by the CFTC agreeing that “a flexible approach to defining what constitutes an organized platform for derivatives trading” was in everyone’s best interest.
MiFID II takes a similar stance on trading style requiring only that venues “have dedicated systems or facilities in place for the execution of trades.” But in this case, the devil is very much in the details. In an attempt to support the G20’s request for transparency, the MiFID II proposal goes on to state that venues “would be required to make its quote both in terms of price and volume available to the public.” In practice this would require RFQ responses to be made public – also known as the transparent RFQ.
It sounds sensible, but with that model the mere presence of a price quote for an instrument that may only trade once a week will alert the market that someone is trading in that particular instrument. This awareness opens the door for aggressive firms to use that information to trade against the firm that initially requested the quote.
A gaping hole for gaming the market is not a good way to kick-off a new regulatory regime. Transparency is good; liquidity-killing information leakage is not.
Promote or Require?
That brings us to another difference in approach – the need for pre-trade and post-trade transparency. Post-trade transparency sees limited debate. Concerns exist around how quickly a trade must be reported and exactly what details must be reported, but by and large post-trade reporting is common across nearly every regulated financial market and no one expects the swaps market to evade that requirement.
The EC and the CFTC both like pre-trade price transparency as well, but what they expect of the swap venues in this regard is different. The CFTC states that a SEF must “promote” pre-trade price transparency whereas MiFID II would “require pre- and post-trade transparency for all trades in specific nonequity products, whether executed on regulated markets, MTFs, organised trading facilities or OTC.”
Requiring rather than promoting pre-trade transparency leaves many market participants uneasy. In liquid exchange-traded markets, pre-trade price transparency comes naturally as a side effect of the order book model. Since market makers are always posting prices to the screen (in many cases they are obligated to do this) it is possible for a potential buyer or seller of that instrument to get an idea of the current market price for the instrument before deciding to interact with the market. In traditional OTC markets and RFQ markets, it’s not so easy.
The swaps markets these rules are intended to reform are relatively illiquid, with some instruments trading only a few times a day, or even a few times a month. The only way to get the current market price is to value it yourself (which may not reflect what others are willing to pay) or ask someone. Asking for a price, via the phone, an RFQ platform or some similar method, constitutes interacting with the market which in turn may tip off the market that you’re up to something. As we already discussed, that’s information leakage.
Because of this distinction, mandatory pre-trade price transparency would undoubtedly drive the use of the order book model even in places where it wasn’t suitable for the liquidity profile of the product. Forcing the use of an order book model would then require dealers to post continuous two-sided quotes. For dealers to safely post two-sided quotes, they would need to keep spreads artificially wide; it’s the only way to limit their downside risk as a market maker. Artificially wide spreads mean that for a trade to be done, a phone call would still be required to get the “real” price. Even if quotes posted to an SEF had to be firm, no one would execute there because they would know that a better price exists under the covers. That being the case, even with an order book model, pre-trade transparency doesn’t really exist as the posted prices create only a range, not the current market price.
The point is that pre-trade price transparency can be very helpful to growing a market but it’s not always possible. By all means we should promote it, but it’s in no one’s best interest to require it.
When will this be settled?
I’ve only scratched the surface. The U.S. and Europe are following the same guidelines – those put forth by the G20 – as they work to reform the OTC derivatives market but we can’t expect the end result to be identical. There is good historical precedent for this: The original MiFID in Europe and Reg NMS in the U.S. had similar goals – to increase competition in the equity markets. On both sides of the Atlantic that’s exactly what we got, but the approaches were very different. For example, Reg NMS spelled out what best execution meant with a focus on price and MiFID left it up to the market participants. These and other differences didn’t drive New Yorkers to London or the French to Chicago, and neither will the differences in the U.S. and European approaches to OTC derivatives.
Unfortunately this won’t be settled for some time. The U.S. will have its final rules in July but the implementation periods for those rules will likely span years as phased in approaches are a must considering the size of the market and the scale of the change. Europe is a bit behind the U.S., but not as far behind as many believe. By the time U.S. rules are really up and running in mid-2012, the European markets will have some closure to their rules.
It would be nice if the U.S. and Europe could agree on a single label for swaps trading venues – it would make the topic much easier to discuss – but that’s unlikely.
If football doesn’t even translate, that leaves little hope for SEF. OTF, MTF or maybe even STF are the likely candidates. But I digress – over the next few years we all have much bigger fish to fry than the name.
Dissent for the block trade rule is still rampant. As the thinking goes, if large swap trades, those that occur in illiquid products that occur weekly or less, are reported within 15 minutes as CFTC proposed rule suggests than the resulting information leakage would cause liquidity (and potentially the market) to dry up completely. There is a lot of truth to the idea that too much transparency is bad thing – but I’m sure there’s a compromise here that will upset the market participants only a little, and allow the CFTC and SEC to look good from a political perspective:
“The latter is a solution that could well be adopted by the CFTC, predicts Tabb’s McPartland. “The regulatory reform process seems to involve the CFTC coming up with a stringent proposal, having meetings with the industry, then keeping the theme of their proposal but scaling back on the details a bit. So if block trades are larger than 95% of other trades now, maybe when we’ve finished they will be larger than 75% of other trades. There’s room for compromise in there,” he says.”
I’ve spent the better part of the last year studying what will become the swap execution facility (SEF) market, how it will be regulated, its players, its impact on derivatives trading. More recently I’ve had the pleasure of speaking with a number of the industry’s leaders in the space regarding the plans for their organizations and how they believe the final rules should look once passed by the SEC and the CFTC.
I thought it was worth a post to create a single view of these conversations and provide a resource to anyone else looking to understand the new SEF landscape. So (in no particular order) here they are:
There are several more firms and individuals out there that play an important part in the SEF debate, and I hope to have similar “on-air” conversations with each. Until then, enjoy.
Execution and clearing mandates for OTC derivative trades are still nearly a year a way by my estimates, but the Street is already getting ready. While Deutsche Bank and Bluemountain Capital executed CDS trades through Tradeweb and cleared via the CME and ICE, Barclays was busy rolling out its new electronic CDS trading product for clients. My comments in the article explain the status of the move to a post Dodd-Frank world:
“Currently there is little demand from clients to trade CDS or other swap products electronically; liquidity is still thin and brokers provide needed market color over the phone,” said Kevin McPartland, senior analyst at research firm TABB Group. “But availability today will leave everyone more comfortable when the big day comes.”