New Value Proposition for a New Swaps Market

Though little remarked on by the major media, regulators’ four-year-old effort to overhaul the $400 trillion over-the-counter derivatives market according to Dodd Frank passed a milestone yesterday evening. An action by the Commodity Futures Trading Commission ensured that, in a month’s time, some of the most widely used interest rate swap contracts must trade only on so-called Swaps Execution Facility (SEF) or on Designated Contract Markets (DCMs), as the futures exchanges are known in the regulatory world. (See report on CFTC action here.)

Ultimately, the Commission is expected to impose mandatory SEF or DCM trading as well as central clearing on a wide range of more or less standard OTC instruments, including credit default and foreign exchange swaps. This represents the final stages of implementing the reforms envisioned by Dodd Frank legislation passed in 2010.

At its core, Dodd Frank sought to reduce systemic risk by boosting market transparency. To achieve that, regulators are forcing a large portion of the OTC swaps market onto SEFs or exchanges and requiring central clearing of transactions. Further impetus for this shift comes from collateral and margin requirements that penalize non-cleared transactions.

Though the CFTC initial mandate on SEF trading doesn’t officially kick in until February 15, SEFs have been trading these instruments provisionally since last October, in expectation of the regulatory actions. And futures exchanges have already launched a number of products designed to mimic standardized OTC swaps products.

The changes sweep away much of the over-the-counter world of bi-lateral trades, built on the web of relationships among the global investment banks, their clients and the inter-dealer brokers. Emerging in its place is a highly fragmented trading environment. About 21 SEFs have registered to trade multiplicity of products, using many different types of trading protocols.

Given the breadth of change, the investment banks (a.k.a. the dealers) are retooling their business models and their value proposition for clients. Though much of the swaps markets will move to SEFs and exchanges, there compelling reasons that dealer relationships will remain important to buy side institutions. There are many areas in which dealers will be able to offer capabilities that will help buy-side clients deal with these challenges inherent in the new market structure.

First, achieving “best execution” in such a fragmented, fast-evolving market will require significant technology resources. The arrival of SEFs represents a wave of “electronification” of what had been bi-lateral, large phone-based market. Navigating this highly fragmented, electronic trading environment will pose a challenge to fiduciaries.

Dealers bring expertise at price discovery and aggregating liquidity in electronic markets. Some will be in a position to offer automated trading capabilities in higher volume markets.

Second, the operational demands of managing relationships with multiple SEFs as well as other markets will be daunting for some clients. Not all clients meet the requirements for access to the clearers connected with SEFs. Even those who do may not feel comfortable with the requirements of a particular SEF.

Another significant challenge will be managing collateral and margin requirements across the range of trading venues and products. Efficient deployment of collateral and margin will have a significant impact on buy-side investment performance.

Many observers see parallels with the development of the equity market, where the rise of electronic trading and major shifts in regulatory policy lead to fragmentation and huge change in the trading environment. To some eyes, the coming change in the derivatives markets looks to produce an even more complicated jumble.

In this environment, dealers have begun to describe their value proposition in the new market as an “agency model” or one built on the concept of “introducing broker.” The dealer offers client “sponsored” access to liquidity across a range of trading venues, supported by advanced trading technology, data and clearing resources and expertise.

In this context, dealers will differentiate themselves on how well they deliver an integrated set of services that address clients’ concerns about best execution, risk management and optimization of collateral and margin.

Bill McBride
January 17, 2014

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