Senator Lincoln is backing down slightly from originally proposed derivatives amendment. Its still far from reality in my opinion, but we’re getting there.
“The fact the [legislation] is so broad-reaching may cause problems for small banks that already have capital constraints and are also not budgeting for the legal ramifications of this,” said Kevin McPartland, a senior analyst at TABB Group.
Full article at Wall Street Journal Professional
If OTC Derivatives reform is passed as it is in the Senate there is a real chance the majority of OTC derivative trading that goes on today in the US
will move offshore. This might sound like a great outcome to those that believe derivatives are the root of all evil, however the reality is that would eliminate jobs, millions in tax dollars, make credit considerably harder to come by and actually remove transparency from the market as US regulators would have little control. My comments on ABC News:
“This is not just posturing,” insisted Kevin McPartland, a senior analyst with the TABB Group, a New York City based financial markets research firm. “We have had conversations to show there is real concern in the banking community. The laws are extreme enough that banks would have little choice but to move some, if not all, of their derivatives business offshore.”
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“In an effort to further regulate derivatives and proprietary trading, the U.S. could actually lose oversight,” TABB’s McPartland said.
Read the full story at ABCNews.com
Doesn’t sound like anyone is particular excited about the bill passed last week in the Senate. Even only half of the Senate (the Democrats) seems to like the final product. My comments in the article:
Some industry professionals believe Sen. Blanche Lincoln’s provision requiring banks to spin off their swaps desks will get kicked out when the bill is merged with the less restrictive House version in June. “It seems pretty widely believed that when they go to conference, the house will take it out,” said Kevin McPartland, a senior analyst at the TABB Group in New York told Derivatives Week.
Full article at DerivativesWeek.com
My thoughts on the Senate’s passage of Financial Reform – originally posted on TabbForum.com
The US Senate has passed its version of financial regulatory reform that will include serious changes, some expected, some not, specific to the OTC derivatives market. The passage of this bill will lead to a compromise bill created jointly by the House and Senate and ultimately President Obama signing it into law before 4th of July barbeques are under way. Although its contents are questionable, getting the bill out of the Senate is a good thing as the Hill will finally be removed from the Street.
But as we’ve learned during the entire, multi-year reform process, the devil is really in the details and unfortunately many of the details continue to be a bit hazy. At last check, there were 434 proposed amendments to the Senate bill. Most of these amendments will fall by the wayside now as the Senate was anxious to move the process along, but sorting out and knowing what’s in, what’s out and what replaces what may well require a gaggle of Congressional staffers. Even with the final text made clear, most of us at TABB Group are left trying to decipher the “spirit” of the law.
I am not a congressional staffer (I prefer the subway frankly, not the Metro) but what follows are several of the key OTC derivative reform issues and where they stand.
Senator Blanche Lincoln put forth an amendment to replace the original OTC derivatives reform text in the Dodd Bill. It is the contents of the Lincoln Amendment that provides the Senate’s plan for OTC derivatives. Although the plan is similar to what the House passed in December 2009, it creates a more onerous (and market-growth inhibiting) structure for OTC derivatives. One provision within that amendment stands out above the others, and will continue to be the source of great debate as the bill goes to committee.
Senator Lincoln proposes that banks that trade OTC derivatives would no longer be allowed access to the Fed, FDIC or other emergency funding sources for banks. What this means in practice is that banks would need to spin off their swaps businesses into separate legal entities, a provision that is not good for the market, period (but that is a debate for another time).
We have learned through various sources that this provision may yet be dropped when the Senate and House meet to create a compromise bill. The support for this particular provision of the bill has decreased dramatically in Washington during the past weeks, making it less likely the proposal will become law. However, given the poor optics of being soft on banks, the escalating punitive nature of the regulation in recent weeks, the impending election and the stick nature of the Lincoln Amendment despite lobbying efforts the fate of this provision will remain unclear until a compromise bill is approved.
The so-called Volcker Rule that would ban banks from engaging in proprietary trading is also included in the Senate bill, despite the defeat of an amendment that would put additional restrictions on how banks trade with their own capital. Although this provision seems too extreme to make its way into the compromise bill, populist fervor and support from other prominent politicians makes possible some ban on proprietary trading at banks. This would have significant implications to bank earnings and the prominence of the US in the global capital markets.
Mandates for central clearing and trading through a registered execution venue are a near guarantee as both the Senate and House (not to mention Democrats and Republicans) see these moves as necessary to increase transparency and therefore reduce systemic risk. Exactly who falls under these mandates, however, continues to be a source for debate. The Senate bill provides few exemptions as compared to the House bill and would likely force firms with no systemic importance to centrally clear certain trades, which means they would need to put up additional margin, ultimately putting an undue burden on these organizations’ balance sheets. The exact wording of the law is also important. For example, if Swap Execution Facilities are defined as “trading facilities,” then technically, phone-based transactions would become illegal based on the definition in the Commodities Exchange Act.
Other amendments that passed increase the CFTC’s power in dealing with market manipulation, raise capital standards for banks trading OTC derivatives and put heavier regulations on the trading of mortgage-related derivatives. One notable amendment that was not passed was a proposed ban on the trading of naked credit default swaps. We’ll leave that to Germany for now.
For the next month, all eyes will be on the discussions between Representative Barney Frank and Senator Chris Dodd as they work out a compromise bill. The Lincoln proposal to spin-off swaps desks, a potential proprietary trading ban and far-reaching clearing and execution mandates could be game changers for the entire market based on the bill’s final wording. K Street lobbyists will remain close to the Hill to push for these proposals (such as those by Senator Lincoln to spin off bank swap desks and the Volcker Rule), to die.
The debate will not end at President Obama’s desk. As I’ve discussed in previous papers, the rule-writing process at the CFTC and SEC will become the next focus as regulators work to implement the laws passed by Congress. Keep an eye out for comment periods and continued fierce debate.
While the House bill may be closer to a realistic solution than the one passed by the Senate, the Senate bill may be closer to what gets passed, given the current, charged political environment and the pressure not to side with the banks.
TABB Group believes that the bill that passes will go inevitably too far in some cases, likely making the clearing mandate, for example, impact more firms that is necessary to reduce systemic risk. Unfortunately, this situation has become more about politics (bipartisan issues, reelections, etc.)And less about market structure.
Some reform is good, but going too far will be just like putting your car up on cinder blocks to ensure it doesn’t get into an accident.
The forthcoming bill from the Senate Ag committee seems to take us back to early 2009 when legislators thought the entire OTC derivatives market could be moved on exchange. All I smell here is politics, and a huge lack of effort to create the best new system for regulating derivative, instead thinking only about re-election. My comments via video:
We should get much more information about the Senate’s view on OTC derivative reform on Friday when the first amendment to the bill is expected. In the meantime:
While most derivative pros did not expect the broader definition in Dodd’s revised bill, they believe the Reed-Gregg amendment will focus heavily on exemptions. “The way it feels to me is…the true end-user firms, the non-financial corporate firms, airlines, construction companies, etc…believe they will mostly in the end be exempt,” said Kevin McPartland, a senior analyst at TABB Group. “There are too many downsides [to forcing clearing on them]. I do think they will put language that will include a lot of the major hedge fund and buyside firms that are heavy into derivatives.”
Full article at DerivativesWeek.com (subscription)
My Senate Testimony on Swap Execution Facilities
This is my written testimony for the Senate Banking Committee hearing on July 29, 2011 focused on Swap Execution Facilities. What I actually said at the hearing was a subset of this. You can watch (rather than read) the entire hearing on the Senate Banking Committee website here.
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Chairman Reed, Ranking Member Crapo, and Members of the Subcommittee, thank you for inviting me today to discuss progress and concerns surrounding the creation of swap execution facilities.
I’m Kevin McPartland, a Principal and the Director of Fixed Income Research at TABB Group. TABB Group is a strategic research and advisory firm focused exclusively on the institutional capital markets. Our clients span the entire investment landscape including investment banks, pension plans, mutual funds, hedge funds, high frequency traders, FCMs, exchanges and clearinghouses. We also operate TabbFORUM.com, a peer-to-peer community site where top level industry executives share thought leadership on important issues affecting the global capital markets.
In order for this new market structure to be successful, swap execution facilities must be given broad latitude in defining and implementing their business models – this includes, but is not limited to, the mechanisms used for trading and the risk profiles of their members. This will promote the innovation and competition that has made the US capital markets the envy of the world.
It is also critical that the mechanisms to move trades quickly and easily from execution to clearing are well defined. If market participants worry that the trade they have just executed on a SEF might later in the day be canceled due to a clearinghouse rejection, confidence in the entire market model will erode quickly, and severely limit the transparency and systemic risk reduction the Dodd-Frank Act was intended to improve.
New Market Structure
Despite these open concerns, industry sentiment toward the creation of swap execution facilities has turned positive. Based on a TABB Group poll published in April 2011, of more than 140 market participants, 87 percent believe the creation of swap execution facilities will ultimately be good for the swaps market. Of course, everyone defines “good” differently – good for liquidity, for transparency, for profits. Regardless, this demonstrates how the market’s view that nearly every business model can – and most will – be adapted to work under the proposed SEF rules.
That being said, no solution will satisfy all market participants – nor should it. Regulators should not try to appease everyone in the market but instead focus their efforts on creating a set of rules that work.
To finalize the new swaps-market rules, regulators can either attempt to fit these products into old structures (such as a futures structure), or develop new mechanisms to manage these products. TABB Group believes regulators should look toward the new rather than wrap a new product in an old package. To that end, we are all presented with the rare opportunity to build up this market from scratch in such a way that it will function effectively for farmers who need to hedge crop prices and global financial institutions working to keep the world’s economy flowing.
The exchange model was created over two hundred years ago long before electronic trading and high-speed market data. Today we’re creating a new 21st-century market, but why would a paradigm from the 1800s make sense as a starting point? With little legacy legislation, rules can be written based on what we know now, not based on the structures developed in 1934 via the Securities and Exchange Act.
Trading Style and Membership Requirements
In order to develop the most suitable market structure for swaps, we must provide swap execution facilities with the freedom to utilize trading styles and different business models, ensuring every market participant has the most efficient access to liquidity possible.
Firstly, SEFs should not be driven to a particular trading model. Despite the inclusion of the Request for Quote model in proposals from the CFTC and SEC, regulators are keen to have swaps trade through an order book with continuous two-sided quotes.
TABB Group research shows that order-book trading will emerge naturally – 81% believe we will have continuous order book trading of vanilla interest rate swaps within two years of SEF rule implementation. However, the existence of an electronic order book does not guarantee liquidity nor that market participants will trade there.
For example, of the roughly 300,000 contracts available for trading in the electronic US equity options market, trading in the top 100 names makes up nearly 70% of the volume. The rest are seen as so illiquid that it is often easier to trade OTC with a broker rather than try and execute that same contract on the screen. Furthermore, despite the market’s electronic nature, TABB Group research shows that in 2010 as much as 97% of all options trading volume generated by asset managers was done over the phone.
Second, we should encourage SEFs to set membership requirements to encourage a variety of liquidity pools. The US equity market presents a good example. Thirteen registered exchanges and another 55 alternative execution venues exist to trade US equities for a total of 68. Why? Because different market participants trade in different ways and have different needs. Some like to trade in large size, some small; some are very concerned about price while others are more concerned about getting a trade done quickly. Because of this, the equity market responded with new venues to meet those needs.
Although the equities market is very retail focused and the swaps market is purely institutional, a similar dynamic exists. The trading style and needs of a mutual fund are very different from those of a major dealer or a hedge fund. We therefore should encourage swap execution facilities to develop business models that help all market participants, and allow SEFs to compete with each other for whichever client base they chose to serve. This means allowing SEFs to not only define the method of trading, but requirements for entry.
For example, if you were willing to pay the membership fee, a restaurant supply store would be willing to sell you food for your family in the same bulk sizes they provide for restaurants. But since most American families do not need to buy food in bulk, we choose instead to shop at a local supermarket. The price per unit might be higher, but it is a more suitable way to shop for a family of four. Although the analogy might appear flippant, it explains why loosely defined tiers must still exist for trading swaps.
In the current swaps market, a smaller player cannot trade in the inter-dealer market even if they had the capital and desire. In the new market, as long as a trading firm meets the requirements set forth by the SEF, they will be – and should be – allowed in to trade. The important point to note is that setting membership requirements for SEFs is not exclusionary, but instead intended help market participants trade in the most suitable environment possible.
Clearing
Open access to clearing will play a huge role in the success or failure of all SEFs. It is central clearing, not the SEF construct itself, that will allow easier access to trading and new market participants to enter. But a clearinghouse providing only the ability to accept SEF executed trades is not enough.
SEFs are intent on providing click-to-trade functionality, that when you accept a price on the screen with a click of the mouse, whether in an order book or via a request for quote, the trade is done. However, a trade is not done until it is accepted for clearing – something the SEFs have little if any control over. That raises the question: can a SEF ensure a trade will be accepted for clearing before it allows the trade to execute? And even if it can, is that the SEF’s responsibility?
Either way, clearing certainty is crucial to the success of SEFs. If market participants do not trust that SEF executed trades are firm, confidence in the entire market model will quickly erode. It is critical that a mechanism be put in place to formalize this process, ensuring the market can have full faith in the trades they execute on a SEF.
Size of the Market and Open Issues
There has been considerable speculation as to the number of SEFs that will exist. The wildest number I’ve heard is 100 which is simply unrealistic. If the US equities market has 68 venues and the US futures market has 3 main players, the swaps market will fall somewhere in the middle.
Our research shows also that nearly 60% of market participants believe the ideal number of SEFs per asset class is three to four, resulting in 15 to 20 SEFs covering interest rates, credit, FX, commodities and equities. There will be many more than that to start but not 100 – our list at TABB Group shows as many as 40 firms that plan to apply – but 87% of our study participants believe that SEF consolidation will begin two years or less from the date of rule implementation.
Timing
Rule-writing delays at the CFTC and SEC are unfortunate but necessary. The financial services industry is ready to move ahead to the next chapter, but it is more important that these rules are written properly rather than in haste. Despite the fact that so much uncertainty remains, the industry is moving ahead with preparations for SEF trading, central clearing, trade reporting and the myriad of other new requirements.
We are now in the pre-SEF era. Business models and technology are still being finalized, but most SEFs are “registration-ready” and trade flow is beginning to pick up on the screen as most everyone has accepted that these changes are inevitable. Tradeweb, a trading platform set to register as a SEF, tells us their trading volume is up 47% from last year. We see this level of growth happening with several of the existing platforms. Even if trading mandates don’t take effect until the fourth quarter of 2012 – a timeframe that seems more realistic – the change is so enormous for most swaps traders that getting started now should present just enough time to make the switch.
Winners and losers, however, will not be chosen until after regulatory mandates are in place. Too many market participants still exist and see little economic incentive to shift, in addition to those new market participants waiting in the wings. But even still, working together, regulators and the industry have made significant progress during the past year, clarifying the view of what the post-Dodd Frank world of swaps trading will look like.
As rules are finalized, it is critical that while putting in place necessary oversight, new OTC derivatives rules encourage the innovation and competition that have made the US capital markets the most envied in the world.
Thank you.