This is the PR for my latest SEF report, for which the executive summary can be found here.
PRESS RELEASE
Dec. 8, 2011, 9:33 a.m. EST
Skepticism Grows across the Swaps Markets about Benefits of SEFs Due to Overly Prescriptive Rules, Says TABB
Over 200 Swaps Market Professionals Rate the Top Firms They Believe Will Succeed as SEFs for Rates, Credit, Equity, Energy and FX Asset Classes
NEW YORK & LONDON, Dec 08, 2011 (BUSINESS WIRE) — Three years after the Lehman bankruptcy and one year since the Dodd-Frank Act was enacted, swaps market industry professionals tell TABB Group that overly prescriptive swap execution facility (SEF) rules, specifically the 15-second rule and the 5 RFQ requirement among others, will have a negative impact on liquidity.
According to new research released publicly today, “SEF Industry Barometer: Fall 2011,” skepticism is rising across the swaps markets concerning the benefit of implementing SEFs, says Kevin McPartland, report author, a TABB principal and director of fixed income research. The report’s analysis is based on responses from over 200 buy-side and sell-side market participants in the US and Europe, including dealers, SEFs, interdealer brokers, asset managers, proprietary traders, hedge funds, commercial end users, G14 and non-G14 global investment banks and agency brokers, futures commission merchants (FCMs), IT providers, exchange/clearinghouses and consultants.
Although the CFTC and SEC expect to begin the implementing SEF trading mandates by the third quarter of 2012, over 80% questioned do not expect implementation until 2013. Asked if they believe that SEF formation will be good for the swaps market, nearly three quarters said yes but this is down from 87% as reported in TABB’s April 2011 report, “Swap Execution Facilities: An Industry Barometer,” also written by McPartland.
“Trade sizes for credit default swaps (CDS) and interest rate swaps (IRS) are expected to see the most dramatic decline during the next five years,” McPartland says. Average trade sizes in every asset class — credit, energy, equity, FX and rates — are expected to decline by at least 25%. “The biggest decline is expected in rates and credit.”
Despite concerns regarding overly prescriptive regulation, McPartland points out that there is no lack of interest in this industry sector. Over 43 firms have expressed an interest in creating a SEF, a list available to TABB Fixed Income Research Alliance subscription-based clients and individual firms purchasing the report. Asked who they believe will be successful ultimately as a SEF in each asset class, the participants named the following firms: Bloomberg, CBOE, CME Clearport , CreditEx, FXAll, ICE OTC Energy , ICAP , MarketAxess and Tradeweb.
The complete list of 52 rankings broken down by asset class can be viewed by TABB clients and firms purchasing the report.
“Although we still see little clarity as to how the swaps market will function going forward,” McPartland explains, “that has not prevented the swaps industry from innovating and creating new business models and technology to ensure liquidity in the swaps market remains, despite the frustrating regulatory uncertainty.”
The SEF report with over 20 detailed exhibits is available for download by TABB Group Fixed Income Research Alliance 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.
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 nearly 10,500 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
martinrabkinink
Martin Rabkin, 914-420-5739
mrabkin@martinrabkinink.com
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
martinrabkinink
Martin Rabkin, 914-420-5739
mrabkin@martinrabkinink.com
This is the press release for my latest research report:
Top 15 OTC Derivatives Dealers Set to Spend Nearly $675 Million in 2010/2011 to Prepare Technology for Dodd-Frank OTC Derivatives Trade Execution and Central Clearing Mandates
Spending May Continue into 2012 Based on Implementation Timelines Set by Regulators
NEW YORK & LONDON–(BUSINESS WIRE)–With passage of the Dodd-Frank Act “conferring jurisdiction (on the CFTC and SEC) to issue a rule, regulation or order providing for oversight or regulation of the swaps market,” major change lies ahead. For years, bulge-bracket dealers have been playing defense, trying to hold onto the lucrative market, but in recent months, their strategy has switched to offense. According to TABB Group in a new research report, dealers have had to finally accept that the market will change radically and they need to take the bull by the proverbial horns.
As a result, claims Kevin McPartland, a TABB senior analyst and author of the new research, ”The Future of OTC Derivatives: Swap Execution Facilities and the New Dealer,” TABB believes that the number of dealers handling swaps is set to experience dramatic growth, doubling if not tripling, from roughly 10 in 2010, to as many as 30 by the end of 2011. In order to compete, TABB estimates that the top 15 dealers will spend roughly $385 million surrounding the move towards central clearing.
To create a more efficient electronic workflow instead of the current environment dominated by spreadsheets and dual keying during that same period, TABB also estimates that the top 15 banks will invest $290 million. While only the largest banks have the capacity to come at this from all fronts, McPartland says, “Competition will be fierce at every layer, driven by smaller players with highly focused offerings of their own.”
For now, everyone waits. At final count, the CFTC, SEC, Federal Reserve, FDIC, Treasury Department, Financial Stability Oversight Council (FSOC) and OCC have to write 52 rules to fully enact reforms defined by Congress, specifically the 848 pages dealing with OTC derivatives, which must be in place by July 15, 2011.
Then the real work begins, says McPartland. “The swaps market is going to finally change with existing and new dealers, interdealer brokers, swap-execution facilities (SEFs), clearinghouses, the buy side and every other participant ready to put their best foot forward. But understand the situation: everyone will finally have the information necessary to retool processes, business models and technology to comply. Although the minimum implementation time regulators can set is 60 days, it’s more likely this will take six to 18 months, a reform process that will not be completed until the Olympics in London…in 2012.”
“Regardless of where the chips fall, the OTC derivatives market is in for revolutionary rather than evolutionary change,” says McPartland. “Phones won’t disappear, high-frequency swaps trading will not be born overnight, but the area in between will see these markets grow. While existing bulge-bracket dealers will not die, they’ll change as new dealers emerge with fresh approaches and innovative technology, grabbing a part of the market. No, the OTC derivatives markets aren’t going to wither and die; they’ll grow and prosper. This story has only just begun.”
The 25-page report with 6 exhibits, based on conversations with major and aspiring swaps dealers, interdealer brokers, exchanges, soon-to-be swap execution facilities, legislators and regulators, examines issues to be debated between market participants and regulators and pinpoints winners and losers based on what form the final rules take. It covers how firms are preparing for the new environment; the transition from a dealer-to-dealer (D2D) market; the new dealer puzzle and how participants plan to create a cohesive, cleared OTC derivatives (COD) business; clearing and the futures commission merchant (FCM); compliance costs; sources of liquidity; single-dealer portals; best execution (REG NMS for swaps?); and the block-trading exemption.
The new report is available now for download by TABB Research Alliance Derivatives clients and 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.
About TABB Group
TABB Group is the financial industry’s only 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 Group analyzes and quantifies the investing value chain from the fiduciary, investment manager, broker, exchange and custodian, helping 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 by-invitation-only online community currently with 5,000 capital markets subscribers drawn from buy side and sell side firms, exchanges, regulatory agencies, academia, vendors and media, focusing on thought leadership issues covering current industry-wide topics.
This is the press release for my latest research report on data center networking. You can find a more detailed executive summary here. Now to the PR:
Despite the cost and complexity created by meeting high bandwidth, low latency and global reach requirements sought by capital markets firms trading across asset classes globally, the industry’s current data center-centric server-to-server approach has actually simplified underlying networks.
According to new research by TABB Group, less equipment, fewer hops and robust management tools are allowing networks to actually flatten as they expand. Once implemented, explains Kevin McPartland, TABB senior analyst and author of “Data Center Networking: Redefining the Total Area Network,” servers and networks can run beautifully – “if people don’t get in the way.”
This trend toward simplification has expanded to several areas of the infrastructure where TABB forecasts that globally capital markets businesses will spend $13.4 billion in 2010 on their infrastructures across equities, fixed income, FX, derivatives, commodities and other capital markets businesses, with 41% of that investment occurring in North America alone for data servers, servers, storage and networking.
“Switches are handling much of the work once left to routers,” McPartland says. “As a result, Storage Area Networks (SANs) are quickly becoming an integrated part of Local Area Networks (LANs) and lines between LANs and Wide Area Networks (WANs) are blurring. This is giving way to what TABB calls the redefined Total Area Network (TAN).” Using the Total Area Network, he explains, network equipment and protocols will be more standardized regardless of their function, and moving data between computers will be seamless despite physical location or the underlying data type. “Those who have the money and infrastructure will see serious efficiencies that will guarantee the return on investment.”
With the server-to server model, virtualization, top-of-rack switches, 10-Gigabit Ethernet (10GE), kernel bypass and other new technological approaches in place and evolving quickly, McPartland believes that although “tomorrow’s flattened network will be simpler to manage, knowing what to deploy, how to deploy it and what to think about based on business needs will be ongoing concerns.”
He gives three examples. According to TABB estimates, in 2010 the network of every major market participant in the US will consume at least 125 terabytes of market data alone with the expectation that no microsecond is wasted and no packet is lost. Second, reducing latency within an infrastructure is centered on removing hops. In a legacy co-location environment, an order message would require 10 hops to move from the client’s order-generating server to the server running the matching engine. A flattening of the network driven by new, faster, more intelligent switches requiring fewer routers can drop the hop count to six, a 40% decrease few trading firms’ CIOs can overlook. Third, assuming a network with 100 switches, which equates to 2,400 ports (physical network connections), a full upgrade to a 10GE environment for a single firm, would cost approximately $1.25 million at a cost of $500 per port, excluding network interface cards and personnel costs for installation.
“Unfortunately, there is no perfect architecture, but by understanding the relationships between latency, bandwidth, scalability and cost,” McPartland says, “the latest and greatest networking technology can underpin an infrastructure that delivers the highest possible ROI. That technology exists today; but since money never sleeps, neither can the men and women designing the networks of tomorrow.”
The 21-page report with seven exhibits is based on conversations with trading firms, network-equipment providers, telecommunications firms and high-speed trading solution providers. It provides a detailed description of how financial services firms are utilizing cutting-edge data center networking equipment and paradigms and discusses tradeoffs between low latency and high scalability and the move to 10GE and beyond.
This is the PR on my latest two reports on optical networking and its role in financial services. Also check out the executive summary here.
North American Financial-Services Firms to Spend $2.2 Billion in 2010 on Connectivity
Two New Research Reports Reveal the Dividing Line between Data-Center and Optical Networking for Capital Markets is Seen Crumbling
NEW YORK & CHICAGO & LONDON–(BUSINESS WIRE)–Long-distance events have grown critical to trading and hedging strategies. While Chicago and New York, London and Frankfort and Hong Kong, Singapore and Tokyo will never be moved geographically, long-distance, low-latency solutions bring these trading venues virtually closer together. As a result, being on the fastest route and employing the lowest latency technology can mean the difference between being first, putting on a hedge or getting completely run over.
“It’s not just about getting orders to the market first, but gathering the information to make those trading decisions before everyone else”
One of the most important of these routes is New York to Chicago. With significant futures and options liquidity in Chicago and the cash markets in New York, being able to move data between New York and Chicago is critical for equity, foreign exchange, fixed income and index arbitrage strategies.
In one of two new research reports published today, TABB Group analyzes the complexities, challenges and opportunities of managing long-distance, low-latency connections and looks at new providers attempting to breach the sub-14 millisecond round-trip route between New York and Chicago.
This is not merely about trading profit, says Kevin McPartland, a TABB senior analyst and author of “Long Distance Latency: Straightest and Fastest Equals Profit,” Low latency futures market data helps sophisticated risk and hedging strategies, generating additional alpha and improving investment returns for many firms. “It’s not just about getting orders to the market first, but gathering the information to make those trading decisions before everyone else,” he explains.
During the past few years, latency reduction has focused on writing better algorithms, using faster machines, reducing network latency, and co-locating at execution venues. However, if roughly 115 miles can be cut from the distance between New York and Chicago, network latency can be reduced from the current 16 milliseconds to approximately 13 milliseconds.
According to TABB estimates, North American financial services firms will invest $2.2 billion for connectivity in 2010, with spending on managed bandwidth for low-latency paths between New York and Chicago to reach nearly $225 million annually. This does not include spending by firms maintaining private optical network, which would add hundreds of millions more to the total.
In the second research report, “Optical Networking for Capital Markets: The Bright Side of Dark Fiber,” co-authored by McPartland and contributing analyst Andrew Cartine, TABB says the need for speed has created a dramatic priority shift, forcing network engineers to relearn the rules. This new approach to technology deployment has begun to manifest itself in every cog of a trading organization’s technological wheel from how engineers program to how financial markets firms are buying their own dark fiber optical networks.
According to McPartland, a typical proprietary trading firm pulls in over 400 gigabytes of market data daily and generates 20 gigabytes of FIX traffic between itself and the markets, activity generating roughly 1.5 terabytes of input and output each day between core trading data centers and auxiliary counterparts. “A shop like this is spending millions of dollars just to move all this traffic back and forth between data centers, which is why, put simply, the goal today is to reduce the places data must go before trading decisions are made.” Choosing how you acquire network connectivity is not a decision to be made lightly, the authors claim, as running a fiber network essentially turns a trading firm into a telco provider with just one customer.
Moving forward, they point out, the dividing line between data-center networking and optical networking is crumbling. Many trading firms already view the multiple data centers in New Jersey as one big virtual data center whose networks seamlessly move traffic between disparate servers with less than 100 microseconds of latency added by jumps on and off the optical path.
With latency reduction no longer confined to the data center, now involving the miles of conduit carrying fiber optic cables, trading volumes will only increase and matching engines will only get faster. Says McPartland, “Only those with a deep understanding of how their data moves around the world will remain competitive. Reducing latency and increasing bandwidth is all well and good, but just counting on Moore’s and Metcalfe’s Laws doesn’t cut it anymore. Firms need to optimize their infrastructure, rather than expand it with brute force. Even for firms that count every last microsecond, it’s a misconception they’ll pay anything to cut latency. In the end they are still businesses looking to keep costs low and revenues high.”
“Optical Networking for Capital Markets,” based on conversations with trading firms, optical equipment providers, telecommunications firms and high-speed trading solution providers, gives a detailed description how fiber optic networks are used by financial services firms and potential pitfalls inherent in gaining access to and utilizing an optical network. The report discusses sources of latency, bandwidth usage, methods of accessing fiber optic networks and optical equipment providers and provides estimates for optical connectivity spending by financial services firms. “Long Distance Latency” outlines the importance of reducing the time it takes to trade and market data messages to travel between two cities, how that can be done and those firms most likely to succeed.
Both reports are available now for download by TABB Group Research Alliance Equities clients and 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.
About TABB Group
TABB Group is the research and strategic advisory firm focused exclusively on capital markets, with offices in New York and London. Founded in 2003 and based on 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 managers and brokers to exchanges and custodians, helping senior business leaders gain a true understanding of financial markets issues. For more information, visitwww.tabbgroup.com. In January 2010, TABB Group launched TabbFORUM, www.tabbforum.com, the online community where capital markets professionals share and contribute commentary on current industry-wide issues.
This is my latest research report looking at the buy side’s usage of trading technology. See the press release below, the executive summary at tabbgroup.com and coverage of the study from Securities Industry News and Advanced Trading.
NEW YORK & LONDON – (Business Wire) According to new research from TABB Group, the integration of order management (OMS) and execution management system (EMS) functionality is now the driving force in streamlining the buy-side’s desktop. Although nearly 50% of the buy-side trading community receives OMS and EMS technology at virtually no direct cost through their broker relationships, TABB forecasts a 5% and 1% CAGR (compound annual growth rate) in OMS and EMS technology spending, respectively, between 2010 and 2012, by buy-side firms.
With 100% of TABB’s research study participants now using an OMS, EMS or both, the buy side’s top priority, says Kevin McPartland, senior analyst who authored the study, “The Buy-Side OMS and EMS: Integration, Expansion and Consolidation,” has switched from widgets and algos to integration. “With an eye on the middle office, back office, reference data system, analytic package or real-time market data, the trading-floor bouncer is working hard to throw double keying out the back door.”
However, McPartland notes, brokers’ ability to provide trading platforms gratis to all of their buy-side customers will shrink in the next three to five years as TABB Group believes the buy side will begin paying for these connections as brokers follow a cost-conscious approach to order-flow acquisition. They also believe that the 3% fewer buy-side firms using broker-funded EMSs in 2010 than in 2008 signals a trend. A strong increase in spending hard dollars for platforms further highlights the model shift. “While existing practices will not die, in the future, brokers will be as willing to foot the bill for connectivity as a guy is to foot the bill for dinner after a bad date.”
McPartland says that adoption rates show US equity-focused, buy-side firms rely completely on front-end trading technology. “In 1996, adoption levels were at 96%. Four years later, we’re at 100% and while that 4% jump might not appear large, it represents 400 to 500 new customers for platform providers. For OMS/EMS providers, competition is fierce. Even though black boxes now generate a disproportionate amount of volume, trading systems act as the gas, brake, steering wheel and airbag. With no cash-fort-clunkers program in sight for Wall Street, innovation, integration and old-fashioned customer service are factors in how vendors differentiate themselves and determine which car the buy-side drives.”
He also points out that the average number of EMSs on the buy-side desktop dropped from an average of 3.4 in 2008 to 1.6 in 2010 due to management demands for greater execution efficiency, true multi-broker access via a single platform and a push by EMS providers to be one-stop shops.
Analytics, charting, algorithms, risk management, P&L calculations and other core trading-system functions will see incremental improvements over the next several years, and that multi-asset and multi-geography access will become more common and robust as platforms once focused on a single market or asset class expand outward. “Co-opetition between platform providers will grow,” McPartland says, “and become more contentious due to expansion into new areas that will step on toes and strain partnerships.”
The most dramatic changes will take place under the covers, he adds. “Integration between EMS, OMS and the other systems that make up the complete trading lifecycle is the hottest issue for buy-side firms, and providers will need to work diligently to ensure inter-system connectivity is seamless and quick to implement. However, despite the efforts of some to merge the OMS and EMS into a single platform, messaging technology and protocol standards will allow disparate systems to communicate as if they were one.”
He notes, though, that there is no consensus between buy-side traders concerning their desire to merge the OMS and EMS into a single OEMS, due to their concerns over adopting an unnecessarily complex system.
The 40-page study with 37 exhibits is based on interviews with 118 US-based buy-side traders, split approximately 50% among hedge funds and traditional asset managers. One-to-one discussions covered system usage, likes and dislikes, business drivers, changing requirements and what traders expect to see from OMS and EMS providers going forward.
The study is available now for download by TABB Group Research Alliance Equity clients and pre-qualified media athttps://www.tabbgroup.com/Login.aspx. For an executive summary or to purchase the report, visit http://www.tabbgroup.com or write toinfo@tabbgroup.com.
A video summary of the study is also available at TabbFORUM, www.tabbforum.com, the online community for capital markets professionals.
Also available on TabbForum.com
On March 14, 2010 Senator Dodd and the Senate Banking Committee released their latest Financial Reform Bill. Broadly speaking, the few
hundred pages of this bill dedicated to reforming the OTC derivatives market showed few major changes from either the previous Senate bill release in November 2009 or the House Bill passed in December 2009. This does not come as much of a surprise as the major tenets of OTC derivative reform appear to be decided – standardized products will be traded through a registered platform and centrally cleared, dealers will register with the SEC and/or CFTC based on the products they trade and all OTC derivatives trades not cleared will be reported to a trade repository and subject to margin requirements. The devil however, continues to be in the details.
One point of contention that will be worth watching over the next few weeks, as the markup process begins and Sens. Reed and Gregg make public their amendment focused on OTC derivatives reform, is the definition of Major Swap Participant. A lot hinges on how that three word term is defined, most importantly which firms must adhere to execution and clearing mandates and which will be exempt. Both the House and Senate bills tell us that both parties to any given trade must be either Dealers or Major Swap Participants for the trade to fall under the execution and clearing mandate. The major dealers will most certainly be regulated, but for larger hedge funds and major end user firms who’s role in the market is up for debate, avoiding the mandate could save them millions while allowing them to keep control over what they execute in the open and what they centrally clear.
The root of this debate is systemic risk. Those firms deemed systemically important should be more heavily scrutinized then those that are not. While the distinction might be obvious for some (think JPMorganChase or Citigroup) it is less obvious for others (Citadel or Bluemountain Capital, for example). If one of the aforementioned dealers was to file bankruptcy the impacts on the global economy would be massive. Global markets would scramble, retail investors would withdraw money and uncertainty would hang over who might be next. We’ve seen this happen recently, so the situation requires no further explanation. If a major hedge fund was to file bankruptcy however, the results are much less clear.
Investors in that fund would lose money. Many people within the firm would lose their jobs. Other market participants would also lose money based on their counterparty exposure to the hedge fund. If the firm happened to be a more traditional asset manager, one managing money for “regular” people, even more people would get hurt as retirements accounts could get wiped out. Despite all of the this potential loss and the growing interconnectedness of these “near banks” with major dealers, how systemically important they really are is unclear.
Now back to Washington. The Senate Bill defines Major Swap Participants as those firms “whose failure to perform under the terms of its swaps would cause significant credit losses to its swap counterparties”. That language focuses in on the trading partners of the firm in question, not the broader economy. It also speaks in certainties; “would” cause losses. The House Bill takes the opposite approach. Major Swap Participants include firms “whose outstanding swaps create substantial net counterparty exposure among the aggregate of its counterparties that could expose those counterparties to significant credit losses.” The aggregate exposure can be read more specifically as the broader economy, and hence creating systemic risk. Use of the word “could” broadens the scope of the statement further, proposing that any firm that has the potential to cause systemic risk should fall under the mandate’s purview. I’m splitting hairs over subtle wording differences, but the more I focus on the legislative process the more I understand that’s how it works.
Despite all of the hair splitting over legislative language, it will ultimately be the CFTC and SEC who decide which firms fall where. Beyond the above criteria, firms with a “substantial net position” also will fall in the category of Major Swap Participant, and that number will come from the aforementioned regulators once the proposed bill is made law.
TABB Group is broadly for expanding the use of central clearing for those OTC derivative products deemed suitable; and the more electronic trading and automation the better for most any financial market. However, beyond those firms that show clear systemic importance mandates are less desirable than simply providing access to risk reduction and price discovery tools and allow natural market forces to work.
As for the legislative process, TABB Group believes that we will see something passed before the November election. If that does not happen, than financial reform very well may be DOA. If cooler heads prevail and the President signs the bill into law, regulators will spend 6-12 months writing rules in 2011 with final implementation coming in 2012 right as the Olympics get underway in London. Stay tuned – if this process was a triathlon we’ve only just gotten on our bikes.
The Senate via Sen. Dodd is expected to make public its latest financial reform bill. Although overshadowed in recent weeks but talk of consumer protection an “to big to fail”, the bill will include details of OTC derivative reform. In this video I discuss what we expect, and hope, to see in the Senate’s version of the bill.
What else can derivatives be blamed for? OTC equity derivatives are now in the spotlight of the IRS for promoting tax avoidance. The theory is that an equity swap allows the purchaser to collect dividends on the “swapped” stock without paying the taxes associated with actually owning that stock. I can certainly see the merit in the IRS’s argument, but where do we draw the line between tax avoidance and smart investing?
Determining if SEF Aggregation Really Matters
This post also published at TabbFORUM.com
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
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.
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.
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”