The FT published a great special section this past Monday on the state of OTC derivatives reform. Coverage ranged from the im
pact of MF Global on margin and segregation rules to technology innovation driven by the new rules. What these stories all reaffirm is how much the details of the final rules will impact liquidity, product selection, the growth of electronic trading and what set of tools will ultimatey be most valuable in helping market participants come out on top.
“As volatility alone can cause rapid intra-day deterioration of major counterparty credit quality, a move
towards near-time or realtime clearing is inevitable anyway,” said Kevin
McPartland, fixed income analyst at Tabb Group, in a report last year.…
“Some of the most contentious rule proposals are those that will impact
liquidity fragmentation the most,” says Kevin McPartland, [Principal] at Tabb Group.
The full feature is available at FT.com
It seemed like the CFTC’s meeting yesterday (Dec 12th) would be a
big one; we’d find out the size of a block trade and in doing so get some insight into how truly electronic the swaps market would become.  Unfortunately, the can has been kicked down the road again.  Instead we have a seemingly temporary 30 minute reporting delay for all trades (until block trades are defined) and confirmation that all trades must be reported (a no brainer).
My comments in the Wall Street Journal could have used a little qualifying, as they sound a bit generic out of context (of course market data exists today), but if you’ve read any of my other research you know where I’m coming from. Â Here’s to hoping this market actually can get moving in 2012.
Swaps market analyst Kevin McPartland, a principal with research-firm TABB Group, said the new rules will greatly increase amount of available data on each trade. “We’re going from a world where there was almost no market data to a world where it will be regulated into existence,” Mr. McPartland said, adding that now “everyone will have streaming data on these markets.” He estimates that the Dodd-Frank derivatives regulations will cost the industry $1.8 billion in total but hasn’t separated out the cost for the data rules.
Read the full story here:Â http://on.wsj.com/tszLKA
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.
My conversation with Telis Demos at the Financial Times in NY; we discuss dealer profitability following derivatives reform and how electronic trading could ultimately lead to higher profits. (Click the image below to watch.)
PR on my recent study:
New Annual Fixed Income Industry Benchmark Study Shows 60% of Current Dealers Expect Increased Barriers-to-Entry; Basel III to have Greater Business Impact than Dodd-Frank
NEW YORK & LONDON, Oct 19, 2011 (BUSINESS WIRE) — Despite the risks to liquidity posed by CFTC-proposed regulation, over the long term nearly 75% of existing swap dealers tell TABB Group they believe liquidity will ultimately improve in the post-Dodd-Frank Act era due to increased market participation, further product standardization and electronic trading access.
However, based on new fixed income industry benchmark research published today by TABB, in the first year after Dodd-Frank implementation, nearly 9 out of 10 top-tier dealers and two thirds of mid-tier dealers say they expect profits to remain flat or decline, says Kevin McPartland, a TABB principal, director of fixed income research and author of the new study, “Credit and Rates Swaps Dealers 2011: Redefined and Reborn.”
Regardless of the unknowns, complexities and costs, the dealer community as a whole feels it’s ready for change. “Although lobbying will continue and politics persist,” McPartland says, “dealers see the advantages of a mostly cleared swaps market.” Taking advantage of new opportunities won’t be easy though, as nearly 60% of current dealers believe barriers-to-entry will grow and most expressed doubt as to why non-dealers would want to get into a business where profit margins are decreasing and regulatory oversight is increasing.
The 42-page study with 38 detailed exhibits is based on in-depth interviews with 23 swaps dealers, including everyone on the Office of the Comptroller of the Currency’s top 10 derivatives holdings list; 13 of the 14 G14 firms; 16 of 20 Federal Reserve primary dealers; and the top 11 futures commission merchants (FCMs).
Four key subjects were covered:
– Strategic approaches of both top-tier swaps dealers and new competition
– Future of liquidity in the swaps market and the impact that proposed regulations can have on trading, profit selection and dealer business models
– Swap execution facility (SEF) selection process and how dealers will continue to service clients in an electronic world
– Importance of clearing membership for swaps dealers and their views on clearing access
According to McPartland, his interviews with these dealers, execution platforms and interdealer brokers confirmed that dealer-to-dealer (D2D) electronic trading of on-the-run, investment grade credit default swaps (CDS) index products in the US now accounts for over 80% of total transaction volume of those products, proof that swaps trading is moving to the screen ahead of regulatory mandates. “Even in the dealer-to-client (D2C) market, trading in the CDX.IG is roughly 25% of the total contract volume.”
Dodd-Frank is not the only change weighing on markets. Nearly 60% of the swap dealers interviewed claim Basel III will have a bigger impact on their business than Dodd-Frank. While Basel III doesn’t dictate how a swap must be executed, it does impact each bank’s capacity to fund their swaps trading desk by defining the maximum leverage allowed. Questioning these dealers further, McPartland learned that traders felt Dodd-Frank would have the biggest impact on their day-to-day business and P&L. “But at the bank level, Basel III’s impact would be far greater, that if billions in assets were suddenly untouchable, their business make-up and bottom-line profitability will be affected.”
The study also confirms that over 90% of existing dealers see clearing certainty as a major issue; 95% plan to offer some form of margin financing to clients; and technology was only second to relationships as a strategic advantage after Dodd Frank implementation.
The study is available for download by TABB Group Research Alliance Derivatives clients and all pre-qualified media at https://www.tabbgroup.com/Login.aspx .
For an executive summary or to purchase the report, visit http://www.tabbgroup.com or write to info@tabbgroup.com.
Other recent related TABB research includes: Initial Margin for OTC Derivatives: The Burden of Opportunity Costs; Higher Frequency Swaps Trading: Market Making and Arbitrage; The Changing Environment for Managing Interest Rate Exposure; Interest Rate Derivatives 2011: Collateral Damage in the Duration Market; The Changing Environment for Managing Interest Rate Exposure; and Swap Execution Facilities: An Industry Barometer.
About TABB Group
TABB Group is the financial industry’s strategic advisory and research firm focused solely on capital markets. Founded in 2003 and based on the proven interview-based research methodology of “first-person knowledge” developed by founder Larry Tabb, TABB analyzes and quantifies the investing value chain from the fiduciary, investment manager and broker, to the exchange and custodian to help senior business leaders gain a truer understanding of financial markets issues. For more information, visit www.tabbgroup.com . In January 2010, TABB Group launched TabbFORUM, the online community currently with more than 8,500 capital markets members, drawn from buy-side and sell-side firms, exchanges, regulatory agencies, academia, consultants, vendors and media, focusing on issues covering current industry-wide topics.
SOURCE: TABB Group
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Martin Rabkin, 914-420-5739
mrabkin@martinrabkinink.com
My summer’s work was speaking to every major swaps dealer to try and understand what they’re thinking, how they’ll take their business forward and what pending regulation will do to the swaps market. The executive summary of the report that resulted from these conversations can be found here. Today the FT wrote a story to cover my findings.
So although I’m of course happy for the coverage in the FT, the headline they chose (although attention grabbing) I’m not sure is representative of exactly what we found. Yes, dealers do believe liquidity will ultimately improve but with a lot of caveats. Many combinations of RFQ requirements, the 15 second rule, block trade requirements, margin requirements, etc could severely hamper swaps trading and drive the market to futures and cash products. That said, I am optimistic that cooler heads will prevail and we will not have swaps liquidity Armageddon.
The report talks about much more than just liquidity of course, but you’ll have to read it to find out what (are you in suspense yet?).
One last note – I taped a video about this research as well so keep an eye out for that.
Read the study coverage at FT.com.
The presence of principal trading groups (PTGs) in the exchange-traded derivatives market, and their absence in the
credit and rate swaps markets, are both the cause and effect of turnover frequencies.
TABB Group estimates that proprietary trading (including bank proprietary trading) accounts for 55 percent of futures trading by contract volume and 41 percent of U.S. Treasury (UST) trading by notional. The electronification of these markets increased turnover frequency enough to encourage PTGs to enter, which in turn increased turnover frequency and ultimately liquidity, which led to more entrants in the field, and so on.
Contrary to popular belief, PTGs are not new to the swaps market. Although equities and exchange-traded derivatives made them famous, PTGs play a huge role in the cleared OTC energy swaps market. Although their presence took a hit following the credit crisis and the decline in oil prices, they still drive nearly a third of the volume on ICE’s OTC energy platform.
As with the push for central clearing of fixed-income swaps, the move to central clearing for energy came from an economic catastrophe. Post-Enron, counterparty risk and transparency were huge concerns in the energy market, which ultimately resulted in the establishment of ICE OTC and CME’s ClearPort.
PTGs came into the market around 2005 and quickly picked up market share. For those intimate with the details, the energy swaps market is the prime example of how an OTC-traded, cleared market should work: Two main clearinghouses exist in CME and ICE. Each carries similar contracts in natural gas, crude oil, etc. Those swaps can be traded virtually anywhere: over the phone, via an interdealer broker platform like GFI’s EnergyMatch® or ICAP’s ICAPture®, or via platforms owned by the exchanges.
Once executed, the trades are sent directly to the clearinghouse. Contracts are not fungible — meaning you cannot net a CME natural gas swap with one from ICE. Many larger brokers, though, provide services to essentially move positions from one clearinghouse to the other through a quick buy and sell.
PTGs entered the energy markets as market makers.As liquidity developed they made the move to arbitrage trading. The positive end result has been that spot, futures and swap prices in the most liquid energy markets remain in line with one another as arbitragers performing basis trades keep prices tight. The same progression is on the way for fixed-income markets. Market making will lead to arbitrage trading and ultimately to more efficiently priced markets.
Rick and I discuss the electronification of the corporate bond market, how that will impact swaps trading and SEF creation as well as the steps MarketAxess is taking SEF-if-fy its platform.
Derivatives reform a bright spot? Who would've guessed?
A bank collapse was the catalyst for the reforms currently underway in the OTC swaps market. Debates over liquidity killing regulations and overly burdensome implementation costs are now the norm. But guess what? The swaps market looks like a shining beacon of hope compared to the rest of the finical markets and the global economy.
In case you haven’t been reading the paper, CDS spreads on several major banks out their debt in the junk category, sovereign M&A is started to seem realistic and as can be seen out my office window, lots of people are “occupying Wall Street” rather than working. Things are not that good and reading the Wall Street Journal makes me think we’re back in 2008.
Shift focus to OTC derivatives reform. Where banks are cutting budgets and people everywhere, they’re conversely pouring money into evolving their swaps businesses. New SEFs are popping up monthly with super smart people and ultra cool technology looking to hire more (subtle plug – check out sefjobs.com). And despite some banks expecting stagnant profits in their credit and rates swaps businesses in thr first year following regulation implementation, the need to even maintain profits is huge. Because of these factors and more, the derivatives reform industry is booming.
Ok, it may be that I’m biased as that’s what I focus on all day. It also may be that with things so bad in the markets it doesn’t take much for something to look good. But nevertheless, these new regulations will come in some shape or form regardless of who wins the next presedential election, and so the the industry must understand, plan for and implement change whether they like it or not. For some it’s about remaining relevant, for many others, it’s the opportunity of a lifetime. But either way: Yea rah rah derivatives reform.