With so much focus on execution methods and block trade rules, little talk has been had about another SEF requirement: surveillance. Keeping your market participants in line is no small task. Here is what Javelin is doing to tackle the surveillance requirements.
On Tuesday, December 13th I presented to the CFTC Technology Advisory Committee. Chairman Gensler and Commissioners O’Malia and Wetjan were all there. Each panelist, myself included, gave a 15 minute opening and then we participated in an open Q&A with the Chairman, Commissioners and the members of the TAC.
Maybe I’m just optimistic, but it felt like we actually got somewhere. Chairmen Gensler probed me on the number of SEFs, the importance to dealers of building electronic connectivity to clients and the impact smaller order sizes will have on clearing costs. The other big topics of the morning were order interaction rules and the 15 second rule (which no one but the Chairman seems to support).
The biggest policy question I came out of the meeting asking was will the order interaction rules – requiring the RFQ and order book parts of a SEF to interact – be proposed and passed. I suspect they will still be proposed, but with language that makes using the linkage optional for users. More on this in the coming weeks.
And on a slightly related note, the CFTC just released its proposal defining “made available for trading.” Defining this turn is a pretty critical part in determining how electronic and liquid the post-DFA swaps market will become.
My opening starts about 24 minutes in. Enjoy.
MF Global and the Euro crisis have made people think about counterparty risk again. Counterparty risk concerns are good for clearing, and Swapclear US is all over it. Here are I talk to its US head Dan Maguire about their enhanced functionality, success to date and the “fun” Dan had living through Lehman.
I’m not surprised that multiple firms are competing to be the swap data repository of choice. This is America after all, so if an opportunity exists (especially one created by government mandate) than several firms will go after it. However, I’m not sure I get the business model for running an SDR. Having control over swaps market data is certainly an asset to whichever firm has it, but as most of this data will be made public I’m not sure how valuable that asset ultimately is.
But while the repositories will certainly bring more visibility to the market, their impact on the earnings of the companies that offer them may be smaller. Kevin McPartland, a principal and director of fixed income research at TABB Group, told SNL it is still unclear how profitable providing reporting services would be. He said ICE could look to build out an analytics business on top of the swap data repository as another function in an end-to-end credit clearing business. Another potential business model could be in compiling data from different reporting organizations. “If we end up with multiple [reporting organizations] per region as could be the case, then it seems there could be a business of consolidating SDR data to get a full picture of the market,” he said.
Analytics on top of the data are one possibility. The other driver to run an SDR is not about direct revenue, but instead control. ICE probably figures why should I report my data to DTCC when I can just report it to myself?
Read the full story at SNL.com.
Certainty of clearing is turning into one of the hottest derivative reform debates. The crux of the issue is how can swaps traders be sure that when they execute on a SEF the trade will be accepted for clearing. In most other exchange-like markets the vertical integration makes this a moot point. If you trade equities at the NYSE or futures at CME, the exchange can easily check your single clearing account to ensure you have enough credit to cover the trade.
The swaps market presents a whole new set of challenges, top among them a world in which you can trade the same product on multiple SEFs and clear that same product at multiple clearinghouses – many-to-many. TABB Group research (and my experience) says this problem can be solved with technology, namely pre and post-trade risk checks, rather than a legal agreement. Most of the big banks disagree. I discuss this issue in detail in my recent study on US Swap Dealers.
Karen Brettell at Reuters does a good job of laying out the issue and diverging view points. My comments:
“The documentation issue is still the most polarized of the issues,” said Kevin McPartland, analyst at TABB Group in New York. “It’s very hot or cold depending on who you talk to.”
Read the full story at Reuters.com.
Despite frequent new promises from Washington that rules will be done by a certain date (“Q4 2011 – oh wait, we meant Q1 2012!”) and major market participants stating their readiness it seams like the OTC derivatives reform process will never end. Who’s fault is it? Everyone’s really. Politicians are trying to get reelected (or reappointed) and market participants are working to ensure they can still make money. But – if we removed the bipartisan politics that slows down everything in Washington we could get to the end game much more quickly.
Kevin McPartland, director of fixed-income research at the Tabb Group, the US capital markets consultancy, said disagreements among agencies and lawmakers were a main source of delay. “From our studies, the industry says it’s as ready as it can be … So to me, the delay is politics,” he said.
Read the full story at FT.com
Do people listen to podcasts about financial reform? I hope so. I’m a regular listener of Planet Money’s podcast, so hopefully that means at least someone might listen to me talking derivatives on their iPod (not that I put myself in the league with Planet Money, but know you know what I mean).
In June 2011 at Sungard’s NY City Days conference I spent some time speaking about what we expect to come relating to OTC derivatives reform and its impact on technology (since that was 4 months ago you’ll be able to see if I was drastically wrong on anything). And then just last week I spoke with Rob Daly from Sell Side Technology about derivative reform technology and a whole host of other swap execution facility related issues.
On both counts, please let me know what you think (both in terms of content and podcasts in general).
Sungard: Listen here
Sell Side Technology: Listen here
(also posted on TabbFORUM.com)
Greece is defaulting on its loans.
OK, technically, that’s not true.
The official version is that Greece’s creditors have agreed to a “voluntary” haircut of 50 percent on the outstanding debt. The word voluntary is key. Because the haircut is technically voluntary, a credit event will not be triggered, which means everyone who bought credit default swaps (CDS) on Greek debt will not receive the insurance payout they expected when buying the contract.
It’s akin to crashing your car and the insurance company telling you “sorry, you didn’t crash your car just right so we won’t pay.”
This sets quite a precedent. The financial markets now assume that if a developed market economy is unable to pay its debts, rather than default a structured settlement of sorts will be crafted, which as stated above, will not trigger CDS payments.
That being the case, investment-grade sovereign CDS seem on the surface a bit useless. Why buy credit protection if it won’t pay out when you need it to? That question has led many in the industry to claim that sovereign CDS are now on their death bed.
I disagree. If anyone will kill sovereign CDS, it will be central clearing mandates, not Greece.
How will this play out?
First, legal action is inevitable. Credit protection buyers will sue credit protection sellers. Credit protection sellers – mostly big global banks – will sue someone and everyone in the government related to the agreement. And it goes without saying that industry groups will lobby the European Commission to make changes to the settlement. The interesting twist here is that the agreed-upon solution to the debt crisis is good for the market as a whole, so fighting the terms of the deal to fix the CDS problem is wrought with a conflict of interest.
If Greece were allowed to default, triggering CDS payments, it seems inevitable that at least a few CDS protection sellers would face bankruptcy themselves. That being the case, payment on the triggered CDS would be in question anyway. So whichever way you slice it, a prolonged legal battle is inevitable.
This battle will lead to a restructuring of the terms for sovereign CDS going forward – more of a rebirth than a death. Just as the U.S. government wrote Dodd-Frank in part to “prevent the next AIG,” ISDA, who governs CDS contract standards, will rewrite the terms of the standard agreement to prevent the next Greece. But that still leaves existing CDS holders in bad shape, right? Not necessarily.
Derivative contracts with optionality are often bought by investors with no intention of taking delivery of the underlying asset. Equity options, for example, can be used to speculate on volatility and are often sold before expiry without being exercised. Futures contracts can be used to speculate on the price of just about anything and are often sold before the delivery date. CDS contracts are no different.
According to MarkIt, the spread on Greek CDS in January 2011 was around 1,000 basis points; in late September it went over 4,000. Do I have to spell it out? That means if you bought in January and sold in September, you made a 400 percent return. Not such a bad investment, if you ask me. I also suspect that a substantial portion of those buying up Greek CDS in 2011 never expected a payout and were instead placing bets on the probability of default as shown above.
It has been well known for many months that a solution to the Greek debt crisis might not trigger a credit event, so savvy credit market participants had plenty of time to adjust their holdings and place bets based on this information. And the fact that Greek CDS spreads tightened after the deal was announced shows the market is responding exactly how one would expect – lower default probability, lower cost of buying protection. Does that sound like a dead contract to you?
One monkey wrench in that last scenario is the EU ban on naked CDS. It will be much harder to take such speculative bets if you also must hold the underlying bond. However, I foresee numerous ways around that. No such ban exists in the U.S., at least not yet. It also seems likely that a new repo-like structure will be created to temporarily place the needed bonds with the holder of the CDS for a small fee. That fee will of course impact the profitability of such strategies, but not to such an extent that they will become uneconomical. In the meantime, we can expect to see proxy strategies emerge such as the shorting of national bank stocks in place of shorting the sovereign CDS.
If there’s a good reason for low confidence, speculators will find a way to profit from it.
As one commentator in TABB Group’s soon-to-be-published research on European swap dealers put it, “Trying to contain the Eurozone crisis with CDS short-selling bans is like using concealer to mask welts caused by bubonic plague. You are just masking the symptoms; you are not doing anything to cure the underlying issues.”
That takes us to central clearing.
OTC derivative clearing mandates are going to see the light of day before the end of 2012. As some of the most heavily-traded CDS contracts, sovereign CDS seem likely to fall under these clearing mandates. The Greek situation however highlights the problem with moving sovereign CDS into a cleared environment.
I think my recent quote in Bloomberg News says it best: “Look at Greece possibly defaulting, it’s causing a global disaster. Can you imagine if Germany defaulted? A clearinghouse wouldn’t do any good. There’d be a knock-on effect to every systemically important institution in the world.”
Taking that into account, the only way clearinghouses could clear sovereign CDS would be to set huge margin requirements – potentially 50 percent or higher. That would make it uneconomical to use the instrument for most strategies, essentially killing the contract as we know it today. One of the reasons CDS came into being in the 1990s was to create a cheaper method of shorting the bond.
In the aforementioned scenario, shorting the bond might very well come back in vogue. The other potential end-games include sovereign credit futures or a new structure that does not fall under the CFTC’s definition of swap. It’s important to keep in mind that the financial markets need to manage exposure to sovereign debt (obviously), so structures that provide credit protection cannot completely disappear.
This story is far from over.
ISDA still must make its official ruling on whether a credit event occurred and that could take weeks if not months.
But regardless of how they decide, it’s more likely that Dodd and Frank will kill the sovereign CDS market than Greece.
When automated market-making meets an already liquid market backed by real money trades, arbitrage opportunities quickly follow, which is the direction most liquid portions of the swaps market are moving. Even in this pre-regulation implementation time that continues to linger, adoption of electronic trading is finally starting to gain momentum. Data from Bloomberg, CreditEx and Tradeweb in just the past months show a sharp increase of on-screen execution and despite continued lobbying relating to specific details of each regulatory proposal, the market, by and large, has accepted that the swaps market is going to move to into the electronic age … finally.
For some trading desks, this means spreads will tighten and profits (in the near term) will decline. It is true that spreads in liquid markets such as 10-year interest-rate swaps and index CDS are already tight and some people argue that because of this, there isn’t much profit at risk if spreads tighten further. But if you consider a quarter basis point decline from one-half basis point to one-quarter basis point, that equals billions of dollars in a market that measures its yearly gross turnover in quadrillions.
Fortunately, there’s no reason to fret because both existing and new swaps dealers will continue to make plenty of money. The old adage that it takes money to make money is undoubtedly true here. Changes necessary comply and compete will be costly; a business model that has stood still for nearly 20 years must be recreated and an infrastructure that was designed for weekend batch jobs must be transformed into one that can handle real-time clearing and intraday margin calculations. But once all is said and done, the new opportunities are enormous as a whole world exists, full of untapped trading potential.
The most exciting opportunities exist for firms that are already playing a part in trading the futures and cash fixed income markets electronically. Swaps dealers, principal trading groups and some hedge funds fit the bill. Arbitrage opportunities between swaps, bonds, futures and even FX will quickly emerge as electronic access allows development of automated strategies that before were never possible.
US government debt products are some of the most liquid in the world. Products such as Eurodollar futures and US Treasury futures are both heavily traded and have valuations that are highly correlated to US government debt. Basis trading between these products exists today. Add in interest rate swaps, which can be synthesized using futures and are closely aligned with US debt, and the arbitrage opportunities become clear. Correlations between interest rate and credit products, which throw credit default swaps (CDS) and corporate bonds into the mix, are also compelling trading propositions.
The primary focus will be on relative value trades, i.e., looking for theoretical price difference between two similar structures. For example, a strip of Eurodollar futures could be traded simultaneously with a 5-year interest rate swap when the price of the former isn’t in line with the price of the latter, taking into account convexity bias and differences between swaps and futures.
Statistical arbitrage will exist in the new swaps market but will be slower to develop because historical data that is detailed enough to help determine trading signals and develop automated trading strategies is nearly non-existent. Not until trading, clearing and reporting mandates are all in place will sufficient market and trade data be generated and publically available to make statistical arbitrage trading accessible to most trading firms.
Ironically, creating the trading strategies is seen as the easy part. Several TABB Group conversations with automated trading firms have confirmed that creating algorithms to automatically trade swaps is not much of a stretch. The proposed strategies are not much different than those used for related exchanged-traded products today, and so adopting those algorithms to work in the new swaps market is manageable work. However, creating an infrastructure to gather, consume and disseminate the required data is not an easy task.
Swap execution facilities (SEFs) are also set to gain from these changes, operating as some hybrid of exchange and agency broker, making money not on the direction of the market but on the total volume they process, and automated trading is good for volumes. An upcoming TABB Group study for which two dozen swaps dealers were interviewed shows further potential for SEFs that offer trading in other products. Nearly 80% of swaps dealers believed that those SEFs with an already liquid cash market, whether in US Treasuries or corporate bonds, would have an advantage in gaining swaps liquidity. The ability to execute the aforementioned relative value trades on a single platform is apparently appealing.
Whoever ultimately wins or loses, more automated, relative-value trading can only improve pricing amongst these related fixed-income instruments, leaving the market more efficient for end users and real money accounts. Top-tier dealers will not have smaller trading desks, but desks with a few more computer scientists and a few less MBAs.
Sound familiar?
We’ve been down this road before.
But this time we can build the new market structure with the benefit of hindsight.
The Kevin on the Street Top Ten Stories of 2011