By Ivy Schmerken
More than two years after the near-collapse of the financial industry, the dust finally is settling and sunlight is beginning to pour in. Over-the-counter derivatives - the exotic and mysterious financial instruments that managed to confound even the brightest minds on Wall Street and Capitol Hill - are now being brought out into the open. And many in the industry are on edge.
As regulators draft dozens of new rules to overhaul swaps trading under the Dodd-Frank financial reform law, the industry is coming to the realization that OTC derivatives finally are going to be regulated. The new rules, which are aimed at creating transparency in the nearly $600-trillion global swaps market, will have a major impact on how the buy side executes and clears standardized swaps contracts.
Under the new swaps trading rules, buy-side firms will have the choice of trading standardized contracts either on designated contract markets (aka exchanges) or through a new type of regulated platform known as swap execution facilities, or SEFs. Firms also will be required to post margin through central clearing counterparties, or CCPs.
The new reforms are expected to increase visibility into swaps transactions, open access for investors and smaller dealers to the market through exchanges and SEFs, and produce more bids and offers -- all of which is expected to level the playing field for investors. The anticipated proliferation of SEFs for credit default swaps, credit index products and interest rate swaps, however, has raised new liquidity and fragmentation concerns. And while the rules are not finalized yet, regulators are up against a July 15 deadline - a date that many industry participants feel doesn't provide regulators enough time to get it right.
The New Liquidity Seascape
One of the buy side's top concerns is that liquidity will evaporate. Peter Fisher, vice chairman of BlackRock, the world's largest asset manager with $3.5 trillion in assets under management, says the new market structure is complex and could cause fragmentation similar to the challenges with which the U.S. equities markets currently are struggling.
"As we move into a more complicated market structure with all kinds of vendors and SEFs, we may have to go around looking at prices in all sorts of places," Fisher told the audience at a Tabb Forum conference on OTC derivatives in January. Although Fisher agreed that there will be greater transparency around price, he said it would be more difficult to find depth-of-market transparency.
"Liquidity will go to those who can handle complexity," said Fisher. The winners will be those who can afford to "pour resources into interest rate swaps the way a lot of people trade stocks, with computers whirling trying to break the trades down into little orders," he added, suggesting that algorithms and high-frequency trading would dominate the swaps market.
That is not the way that big buy-side firms like BlackRock have traded in the past, Fisher continued. "We've done huge block trades to figure out how to manage client risk," he said. "Now we're going to figure out how to ping a thousand different SEFs and scrape back the liquidity."
Asked what keeps him up at night, Fisher responded that it would be a flash crash in the interest-rate market.
While he acknowledged that regulators are heading down a "virtuous" path in the name of transparency, Fisher asked, "How much market structure change do we want?" Pointing to the ecosystem that exists between the buy and sell sides, which is based on market confidence, he said it's possible to "transform the nature of liquidity so much that it disappears on us."
Gary Gensler, who as chairman of the Commodity Futures Trading Commission is driving the push for OTC derivatives transparency, has anticipated these complaints. He told Bloomberg News that Wall Street benefits from information advantages and he expects "hundreds, if not thousands, of comments" that the new rules hurt liquidity. But, he said, "I feel it in my core that we're helping liquidity."
Under the Dodd-Frank act, the CFTC and the Securities and Exchange Commission (SEC) are charged with bringing the opaque swaps market under comprehensive regulation. "Markets work best when they are transparent, open and competitive," said Gensler in a recent speech at George Washington University Law School.
Is the Price Right?
The total notional value of swaps has ballooned from $1 trillion in the 1980s to $300 trillion today in the United States. "The contracts have become much more standardized, and rapid advances in technology - particularly in the past 10 years - facilitate more efficient trading," Gensler stated in the speech. "While so much of the marketplace has changed significantly, it remains dominated by a small number of dealers, and pricing and transaction data is not made generally available to the public."
Requiring sell-side firms to trade standardized contracts on either an exchange or on SEFs, rather than over the phone, will create a more fair market, according to James Cawley, CEO of Javelin Capital Markets, an electronic trading venue for credit derivatives and interest-rate swaps that plans to register as an SEF. "People will see bids and offers over the screen," he says, noting that SEFs will be required to be electronic, fair and open. "SEFs are going to bring a tremendous benefit to the buy side, by showing greater transparency in the products, trades, market depth. These are all the benefits that exist in any other market, be it equities or listed derivatives, and now people can come to expect this from OTC derivatives."
Traditionally, the buy side didn't know if it was getting a fair price, Cawley continues. "They took it on blind faith," he says. "Now they can go to neutral trading venues and get best execution." In addition, they'll know that the SEF is a regulated market that protects them against market manipulation.
From an investor perspective, transparency is a net positive, says Abdullah Karatash, head of U.S. fixed income credit trading at New York-based Natixis, which trades the more liquid credit default swaps, single names and index products and is a user of both the MarketAxess and Tradeweb platforms. "Overall, I think all participants would welcome a move to some sort of electronic platform because there's more transparency," he says.
"Currently, you don't really know where things trade - it's not posted unless the dealers tell you," Karatash notes. On an exchange or SEF, however, investors will have no doubt, he says.
The downside of transparency is that "you're giving up a little of the relationship you might have with a broker-dealer," Karatash acknowledges. Because anyone can participate in the SEFs - hedge funds alongside broker-dealers - the lines between the buy side and sell side will be blurred, he predicts.
But Karatash isn't concerned about fragmentation among the various SEFs. "Ultimately, it will converge," he says.
Setting Concrete Rules?
Of course, none of this is set in stone - yet. "Everything is contingent on how the nuts and bolts actually shake out," Karatash points out.
In fact, since there are so many moving parts to the swaps reforms, some market participants question whether regulators and industry firms can comply with all of the mandates by the July 15 deadline set by Congress for Dodd-Frank. The new SEF rules, for instance, take effect within 90 days of that deadline. "The Big Bang approach is going to create a lot of challenges for the industry," said Grant Biggar, president of Creditex, a subsidiary of the IntercontinentalExchange, speaking at the Tabb Forum conference on derivatives reform.
While "the buy side supports the objectives, there are significant practical considerations of getting from where we are today to the end game," says Rick McVey, CEO of MarketAxess Holdings. "There is a concern that they are rushing to set rules that will not be flexible enough to accommodate today's swaps market and that the implementation dates will come too soon for the buy side to make necessary changes to their business model."
Some industry players have stressed that they want more flexibility in the SEF rules, particularly in the required trading protocols for the SEFs. At first the CFTC said it would not allow a request-for-quote (RFQ) model - the buy side's preferred option - which is used in the fixed income markets today. Instead, the CFTC wanted the SEFs to operate more like futures exchanges, using a central limit order book model, but it since has shown more flexibility.
"The buy side in fixed income has preferred the request-for-quote protocol over the exchange trading solutions," says McVey. With the RFQ model in fixed income today, buy-side firms are free to choose how many (or few) dealers they want to compete for their orders. While the CFTC now seems open to the RFQ model for derivatives, it appears it will require investors to go out to at least five dealers on every inquiry conducted via RFQ. The SEC has left open the possibility, however, that investors can go to as few as one dealer on an electronic inquiry.
"The reality is that there are times when the client feels they are better off going to one dealer rather than to a large group," particularly when they have a vey large trade in an illiquid security, says McVey. He adds that buy-side firms often believe that if they go to one dealer privately, the dealer has the time to work off the risk and may be more aggressive in the bid or offer.
Another major change for the buy side is the mandate for central clearing of standardized swaps. "If we are successful at central clearing, a benefit to the customer is they no longer have to go on a bilateral counterparty basis with banks that could fail," says Javelin's Cawley."It's no longer five banks that are bearing the counterparty risk; you have 100 institutions all paying their prorated share of margin contributing to the system. That's how it worked in listed derivatives." In fact, the CFTC's Gensler lowered the capital requirement for designated clearing members to $50 million from $250 million so that the risk would be demutualized across a larger number of brokers.
"The clearing and the trading of swaps are linked," says MarketAxess' McVey. "The triggering event for a swap to be considered a standardized swap is whether it's clearable at one of the clearinghouses. It is those swaps that are eligible for clearing that will have to be traded differently."
The Buy Side's Bottom Line
But while the new regulatory framework may reduce risk, will it reduce costs for the buy side? "Our initial reaction is that it is increasing the amount of margin that we have to put out into the market," says Basil Williams, CEO of New York-based Concordia Advisors, a multistrategy hedge fund manager with $1 billion in assets under management. "So from a risk margining perspective it is less efficient to us than we have been operating in the past."
As a result, says Williams, by definition the system will have less leverage in it. "At the end of the day, that's not a bad outcome," he acknowledges. "But it's putting a little bit more sand in the gears to the way the market functions."
On the execution front, Williams says, he too would have liked to see a more futures-like exchange system developed for swaps. As he currently understands it, his firm will trade with a dealer that will give up the position to a clearinghouse for settlement. "Until you really get exchange pricing, where buyers and sellers meet at a price, having you trade with a dealer and then have those trades given up to a clearinghouse increases your costs," Williams insists.
Further, as risk is shifted away from dealers, buy-side firms will need to connect with a host of entities, including brokers, clearinghouses, exchanges and dozens of SEFs. "There's a lot of things that need to happen," Andrew Downes, managing director of UBS, told the audience at the Tabb derivatives conference.
"SEFs have to build their market models, others need to build central order books, and also everyone interested in trading on the SEFs has to get connected and they have to have clearing in place. A lot has to be done for clearing, and there's a lot of technology [involved]," he said, indicating that it would be costly for the industry.
Kevin McPartland, senior analyst at Tabb Group, says buy-side firms will look to their dealers and their prime brokers to provide the infrastructure they need to clear swaps, but they still will need to make IT investments. "You can't rely on dealers for everything," he says. Big players such as PIMCO, BlackRock and D.E. Shaw, which are as big as banks in some ways, certainly will invest in technology to make sure their systems are capable of controlling the information flows for trading and clearing swaps, McPartland adds.
But for smaller firms, it's going to get complicated. "What our buy-side clients would like is a system that would reconcile the calculations that the clearing members are charging them," relates Jan Petersen, back office domain manager at SimCorp N.A., a global provider of front-, middle- and back-office software, who says each CCP will have its own way of calculating margin.
The CCPs will provide margin requirements to designated clearing members, who in turn will provide them to buy-side firms, Petersen explains. But buy-side firms may have to sign new standard documentation or addendums to their existing investment management agreements (IMAs).
BlackRock's Fisher said that if the stack of documents from the dealers and clearinghouses were too high and complicated, some pension funds in this country wouldn't sign the new agreements. "That would be a loss of liquidity for the derivatives market if people don't want to play," he told the audience at the Tabb event.
But not all clearing is that complicated, some say. "The only thing the customers need to get themselves going is an account at one of the clearinghouses. And they must sign up with one of the SEFs," says Javelin Capital Markets' Cawley.
"It will be a safer market, a more transparent market and a more liquid market," he adds, noting that most asset managers already have clearing brokers that operate for them in the listed derivatives market. "Anyway you consider it, it is nothing but a big positive for the buy side."