By Mike Kent
Bid/ask spreads will increase by 0.2%, implementation costs will exceed USD 750 million, and ongoing operational costs will exceed USD 250 million in implementing the proposed regulatory mandate for electronic execution into the over-the-counter interest rate swaps and options market, according to a International Swaps and Derivatives Association cost-benefit analysis published today.
The mandate, a pivotal part of Dodd-Frank, has drawn criticism from the dealer community. Inter-dealer brokers and swap dealers especially have maintained that electronic execution will apply undue burdens on an over-the-counter market that is already dealing with the prospect of implementing central clearing. ISDA, for its part, has been calling for a government-sponsored cost-benefit analysis of the mandate before rules are finalized.
The Association's analysis found that bid/ask spread's would actually widen, the opposite of the mandate's goal, because post-trade reporting requirements will telegraph swaps market participant activity and ultimately move the market against those positions.
Another goal of the mandate is to increase transparency, which ISDA's analysis concluded would be marginal. "No one is complaining about the lack of transparency," Conrad Voldstad, CEO of the Association, told Derivatives Intelligence. "[Electronic execution] has nothing to do with safety and soundness. Clearing is going to create safer markets. There has been no demonstrated proof at all that the proposed electronic execution mandate is going to improve the marketplace."
The primary argument in support of SEF's, in particular, has been that the market will open up for smaller end users. ISDA's response to that argument is that central clearing will eliminate the credit risk that dealers have traditionally included in their pricing for smaller end users. Eliminating the credit risk will allow dealers to accept smaller end users and reduce the costs associated with pricing in the added risk, they say.
Most market participants agree with that contention. However, others are at odds with ISDA regarding the benefits of execution. The Swap and Derivatives Markets Association estimates that current interest rate swaps trading reaches about USD 22 billion annually, extrapolated from data published by LCH.Clearnet, and that the Dodd-Frank mandate will decrease execution costs overall by about 30%, meaning USD 7-8 billion a year. The lower execution costs, in turn, will allow even more end users to enter the market.
"By letting in more market makers, the market will experience greater competition, which will in turn drive volumes higher and ultimately compress spreads," said James Cawley, co-founder of the SDMA and CEO of Javelin Capital Markets in New York. "The USD 7-8 billion in execution savings are real dollars that end users like corporations, especially, can apply to their own bottom line and their own core business activities."