Dealer with a Capital "D"

Competition among swaps dealers young and old will be fierce, yet what constitutes a “dealer” still remains unclear. Defining “dealer” is important because those who register as Swaps Dealers will face tougher scrutiny-including more reporting and higher capital requiswap dealer chartrements-from regulators. And since the CFTC recently passed a few rules relating to Swap Dealer registration, I thought it would be a good time to review the issues.

There are two sides to the debate over what a “dealer” is: the regulatory definition and the practical definition. The most pronounced regulatory definition comes from the CFTC. According to the CFTC, activities that make someone a Swaps Dealer are:

1. Holding oneself out as a dealer in swaps or security-based swaps,
2. Making a market in swaps or security-based swaps,
3. Regularly entering into swaps or security-based swaps with counterparties as an ordinary course of business for one’s own account, or
4. Engaging in activity causing oneself to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps.

Looking at this definition broadly, the most significant question is whether or not a firm that satisfies some, but not all, of these conditions should be required to register as a Swaps Dealer. Reporting, margin capital and other requirements for registered Swaps Dealers will likely be more onerous, so even firms that aspire to provide liquidity to clients will try to avoid the “capital S, capital D” label. It could be argued that being registered as a Swaps Dealer might act as an ironic competitive disadvantage. Principal Trading Groups (PTG), for example, fall into this bucket (see “Higher Frequency Swaps Trading: Market Making and Arbitrage,” August 2011).

Activity 2 would lead you to believe that PTGs making markets in swaps must, in fact, register as dealers. The bulge-bracket global banks agree. If a PTG is making markets in 10-year interest rate swaps, shouldn’t they be forced to meet the same requirements that major banks have to meet?

TABB Group research has found that this is not the view taken by some regulators in Washington. The “dealer” title is intended for systemically important and highly interconnected firms that trade both cleared and noncleared products. The CFTC proposal goes on to suggest that “dealers tend to be able to arrange customized terms for swaps or security-based swaps upon request, or to create new types of swaps or security-based swaps at the dealer’s own initiative.” None of those activities are, or likely ever will be, of interest to PTGs.

The story is different for banks and FCMs looking to get into the swaps market. In most cases, even if they could structure the business to avoid the Swap Dealer label doing so might not be such a good idea. Over 90% of participants in our US Swap Dealer study expect to register as Swaps Dealers, proof that even those who would prefer to avoid the additional regulatory oversight realize that registering is unavoidable, and probably even necessary to grow in this business (see Exhibit). Whether rational or not, when clients are looking for a dealer to help with their swaps trading, they want a Dealer, not a Major Swaps Participant. Perception in this business is reality.

The more interesting debate is the practical definition of “swaps dealer.” As TABB Group sees it, there are four main roles that swaps dealers will need to fill going forward: executing (agency) broker, market maker, clearing broker and prime broker. The first two roles describe what swaps dealer do today: They provide their clients with liquidity. In the new world, however, client facilitation and market making will likely be split in two, with the former helping clients find the liquidity they need on the appropriate SEF, and the latter acting more as a standalone trading operation.

We’ve already established that PTG market makers shouldn’t have to register as Swap Dealers, but what about an agency only swaps dealer that offers client execution services but requires they clear elsewhere? In that vein, what about those firms who plan to offer clearing and custody services but not engage in active swaps trading?

As new rules hit the Federal Register in the coming months these issues will start to become clearer. However, even when new regulations are final, identifying Swap Dealers from those simply looking for alpha with market making strategies will be complicated. The ultimate goal here should be to regulate systemically important firms and ensure a more level playing field, not to place overly burdensome registration requirements on everyone looking to trade swaps. Here’s to hoping.

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