TABB Group Fixed Income recently published two new research pieces. One for which we spoke with 23 swaps dealers about everything and anything (link here), and the other in which we took a deep dive into what an agency desk for swaps trading might look like and why it matters (link here). The short story, which the WSJ covers in this article, is that the move towards electronic trading in swaps will drive dealers to create a new business model designed to help clients find liquidity in the swaps market rather than making the liquidity for them as principal. In a slightly different way, this model is also enticing to interdealer brokers in asset classes where creating a formal SEF does not make sense for them.
“The interdealer brokers will start opening up access to clients and can start to compete directly with dealers,” said Kevin McPartland, director in fixed-income research at TABB Group in New York.
Read the full article at WSJ.com. And for a deeper dive, please check out the research studies I referenced above.
It seems that LCH.clearnet has been sale forever – well, at least for the last few years. It seems we might finally be getting somewhere. Although in my eyes the prize to be won is Swapclear, the LSE’s motives are different. They want access to the equity and listed derivatives clearing that LCH would bring to the table. Financial analysts have suggested the price tag set by LSE for LCH is too high – but as with most acquisition the buyer is paying for perceived future value as much as actual current profit potential. This is where LCH is worth the price.
I’m also very intrigued about what they’ll do with Swapclear. It doesn’t feel like swaps are in the cards for LSE – so why not sell it off at a premium price to one of many swap focused entities. This issues has been debated at some length on TabbFORUM.
My comments to the WSJ:
Kevin McPartland, director of fixed-income Research at research firm Tabb Group, said that “clearing has so far not shown to be a hugely profitable business.”
“However, being able to offer a full suite of services is becoming more attractive to market participants, and I think that is a large part of why the LSE is willing to pay a premium price for LCH,” McPartland said.
“The premium price will sway the LCH owners to take the money and run,” he said.
Read the full story at WSJ.com
Many still seem skeptical of credit default swaps (CDS), but the reality is (and always has been) that they play an important benchmarking function for the global credit markets. That’s why when I heard that GM CDS was trading without the existing of any underlying GM bond I wasn’t at all surprised.
Two things to keep in mind. First, CDS pricing is always done via models that look at the characteristics of the bond (maturity, interest rate, etc.) and the probability of default (which is determined using formulas, but is essentially an educated guess based on the health of the underlying company). So in this case, despite the lack of any real underlying bond, traders can make some assumptions about the former and have plenty of information on the latter.
Secondly, CDS generally is cash settled. This practice was taken up years ago to prevent a supply/demand imbalance for the underlying bond when delivery is required. Therefore, the lack of an underlying GM bond doesn’t really matter.
My quote from the paper:
“Sure, having CDS without debt looks odd, and people may balk because credit derivatives were at the center of the AIG collapse, but that doesn’t change the fact that CDS prices are the de facto benchmark used to measure the state of the credit market,” said Kevin McPartland, senior analyst at research firm TABB Group.
I can’t find a good link so here’s the story from Dow Jone’s Katy Burne. I think my best contribution is the last quote in the article. Enjoy.
(c) 2010 Dow Jones & Company, Inc.
NEW YORK (Dow Jones)–The Commodity Futures Trading Commission’s decision Thursday to delay a controversial vote on how over-the-counter derivatives should be executed once the Dodd-Frank financial-overhaul bill is enforced took many market participants by surprise.
Some speculated that in the hours leading up to the vote, CFTC Chairman Gary Gensler, a Democrat, received signals he wouldn’t get the support he was expecting from the four other CFTC commissioners. A majority is needed for any proposal to be published for public comment, and a second vote is needed for it to be implemented.
The proposal concerned a new class of trading platform called a “swap execution facility” brought about by the Dodd-Frank law. It would have required the vast majority of OTC derivatives to be traded on futures exchanges or the SEF alternative trading venues in an effort to improve pre-trade price transparency.
The four other CFTC commissioners are Republicans Jill Sommers and Scott O’Malia, and Democrats Bart Chilton and Michael Dunn. Dunn was thought to be the one with reservations, and O’Malia was thought to be opposed. When asked if he planned to vote against the proposal, Dunn declined to comment. Calls to O’Malia’s offices weren’t immediately returned.
In an interview with Dow Jones Newswires Thursday, Sommers said she wasn’t sure why the vote was delayed, but she was going to vote against the proposal because it was too narrow in scope.
“The Commodity Exchange Act defines a trading facility, but the new statute contemplates that SEFs could also be traded on systems or platforms, not just facilities,” she said. “By introducing these new undefined terms into this act, specifically regarding SEFs, it meant we should be looking at a broader model for executing swaps on SEFs than what exists in the futures world today,” Sommers said.
While the proposals released before the scheduled vote were in line with the commission’s earlier guidance, the details were thin and left undefined key terms that could force sweeping changes to the way derivatives are traded, potentially hurting liquidity in the $583 trillion market.
A CFTC spokesman declined to elaborate on the key sticking points behind the delay. The vote was pushed back to next Thursday along with other measures already scheduled for that day.
In an outline before the vote was delayed, the CFTC put forward three solutions that would dictate how swaps must be traded when the Dodd-Frank rules become effective in the second half of 2011.
In the first, swaps that trade with a certain frequency and “exhibit material transaction volume” would have to be executed on exchanges, which use “centralized limit order books” where live prices are made public and trades are executed on a screen for all participants to see.
In the second, swaps that trade less frequently, and that aren’t large enough to be market-moving trades called “block trades,” could be executed either on exchanges or what the commission terms “transparent request-for-quote” systems. Transparent RFQ systems would essentially involve prices being made public before a trade is executed to all participants, not just to the customer that requested the quote.
The third tier would cater to swaps that aren’t block trades, but are customized swaps that don’t trade frequently and wouldn’t be forced into mandatory processing by central clearinghouses. These trades could be executed in a multitude of ways: either by phone rather than on screen; on a request-for-quote SEF where the price is only visible to a limited number of dealers; on a more transparent version of the request-for-quote SEF with every participant seeing all quotes; or on exchange with full transparency.
Which bucket a trade falls into would depend on where the CFTC sets the barrier for what constitutes a block trade, and what it considers to be a trade of “material transaction size” based on average swap sizes lodged in industry data repositories. The most liquid credit default swaps insuring bonds tied to a single corporate-bond issuer trade only 20 times a day, for example, according to Depository Trust & Clearing Corp. data.
In Dec. 6 letter to the CFTC, electronic trading platform Tradeweb wrote that if the rules for SEFs are written too narrowly to make SEFs look like exchanges, they could force existing providers who could qualify as SEFs to unnecessarily change their business models. “The decision by the CFTC to continue debating the SEF rules reflects the importance and complexity of the issues facing the regulators,” said Lee Olesky, CEO of Tradeweb, in a statement Thursday.
The problem is that if dealers in OTC derivatives are required to post prices to all participants in the trading platform at the same time, even if not all participants can execute on those prices, dealers will adjust their prices to reflect the added risk associated with that information being in the public domain and to account for the costs of hedging out their own position.
With those artificial spreads in the market, swaps customers will end up calling a dealer to find out the real price, says Kevin McPartland, senior analyst at independent research firm TABB Group.
The first tier isn’t the issue: On standardized, relatively high-frequency trades, the margins are already thin so they would likely have migrated to exchanges anyway. Dealers call that business “flow” business.
The real battle ground is where the big money is–where quotes still allow for incumbent dealers to build in a profit, or spread, through the request-for-quotes system. According to research from the Swaps and Derivatives Market Association, an industry trade group advocating for derivatives reform, dealers make $60 billion annually from interest-rate swaps and credit derivatives alone by keeping prices private.
“RFQ works, so why are we trying to fix it?” asked McPartland. “It’s not a dealer conspiracy that regulators must rectify; it’s just the way the market works. And the RFQ model had nothing to do with the credit crisis,” he said.
-By Katy Burne, Dow Jones Newswires; 212-416-3084; email@example.com
–Sarah N. Lynch contributed to this article. [ 12-09-10 1623ET ]
First it was shortening the time it takes data to get between New York and Chicago, now its New York and London. The big difference here is that the NY to London route is 3 times longer and has an ocean in the middle – no small feet of engineering and no small price tag.
Such links help inform trading programs that need to consider market data coming out of two separate locations, according to Kevin McPartland, senior analyst with market research firm Tabb Group.
“Say there’s a tick up in the price of a future, and all the stocks in a certain basket will tick up a fraction of a second later,” McPartland said. “If you can see two milliseconds faster where the futures moved in Chicago and subsequently make the stock trade in New York, you can more quickly capture the spread.”
The Wholesale Market Brokers Association of American (WMBA) submitted to the CFTC guidelines as they saw them for what are to become Swap Execution Facilities (SEF). The full submission can be read here. Although this provides some clarity as to what the industry wants, this is only one voice and only the beginning.
The Dodd-Frank law requires all swaps that are standardized enough for central clearing to be traded on a designated contract market, registered securities exchange or what is known as a swap-execution facility. That would include, at a minimum, index credit-default swaps, plain-vanilla interest-rate swaps, and some currency swaps, according to Kevin McPartland, senior analyst at TABB Group Inc.
Goldman formally announced yesterday its new OTC derivatives clearing unit – Derivatives Clearing Services. This is no real surprise as clearly the major dealers are getting ready to help their clients navigate the new, more complicated world. Further, I’m sure we’ll see similar announcements in the coming week from Goldman’s competitors.
This article looks into whether GS and the othesr will allow firms who compete in the execution space to send orders to them for clearing. As you can see from my comments it seems almost a no brainer that they must. Flow, wherever it comes from, adds to the bottom line.
Kevin McPartland, senior analyst at research firm TABB Group, said he believes more dealers will announce similar OTC clearing business models based on the new laws. “They’ll look at OTC as more of a cross-product business that wraps in with prime brokerage and execution.”
Some major dealers may even decide that diversifying their revenues by allowing smaller dealers as well as customers to clear trades through them will help to offset business that will be lost as a result of the new regulatory restrictions on bilateral, uncleared OTC trades. “The OTC clearing business is clearly going to be a lucrative one over time, so it’ll be all about capturing flow,” said McPartland.
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.
Everyone is still trying to understand what happened on May 6. Stub quoting was certainly not the overall cause, but might help to explain why a few stocks went to a penny.
“If we end up with the trading curbs across all the trading exchanges that have been discussed, it would make this become a non-issue,” said Kevin McPartland, a senior analyst with research firm Tabb Group.
Hardware acceleration has become a hotter and hotter topic in financial services as latencies are now measured in microseconds and codeoptimization is starting to hit its limits for the upper echelon of low latency traders. I authored a TABB Group report on this subject in the summer of 2009, and recently spoke with Hanweck Associates about their use of GPUs to speed up options analytics. The fact that the Wall Street Journal is covering this also talks to the level of acceptance and adoption that hardware acceleration is seeing.
“When you’re talking about trading where microseconds make a difference, the extra hops within the server can make a difference,” said Kevin McPartland, a senior analyst with research firm Tabb Group.