Swaps trades on brink of tough new regime

By Stephen Foley and Michael Mackenzie in New York


On any long journey, some steps are more important than others. The new Wall Street envisioned by the Dodd-Frank reforms in the US no longer has financial institutions swapping hundreds of billions of dollars of interest rate, commodity and credit exposure among themselves, in opaque trades that threaten to pull everyone down together in a crisis.

In the new order, swaps trades have to go through a central counterparty, or clearing house, so that the failure of the institution on one side of a trade does not harm the other, and the trades themselves should be made on a trading platform, where the parties are much less likely to be price-gouged or otherwise mistreated by intermediaries.

After intense lobbying and delay, the new order is emerging, and some of the most important steps are being taken now, with swaps being centrally cleared in increasing numbers.

Swaps dealers will have to register with the Commodity Futures Trading Commission from the end of this year, following a rule change that went live last week. Mandatory clearing for all but the most unusual swaps will kick in shortly after that. New futures-type exchanges and so-called swap execution facilities, or SEFs, are being set up now in the expectation that central clearing will lead to anonymous, electronic trading.

Fred Dassori, head of electronic market making at Credit Suisse, says: “There is still a lot of uncertainty about what the market will look like, but one thing is clear: this is the biggest phase of turbulence that the derivatives market has gone through. You are taking 80 per cent of the market and changing the way it trades.”

While banks have cleared some swaps for many years, such risk management efforts occurred days or even months after trades were executed. The failures of Lehman Brothers and AIG threatened huge losses for their counterparties in uncleared swap trades, and the demand for clearing by investors has only accelerated in the wake of the eurozone crisis.

Under its new powers, the CFTC is demanding US swap trades are cleared inside a minute, partly to reduce the risk of having trades in limbo and partly to facilitate electronic trading.

“Once clearing is fully deployed across the entire market, it will make it a lot easier for investors to trade anonymously with each other as the bilateral counterparty risk of trades is eliminated,” says Lee Olesky, chief executive at Tradeweb, which plans to set up an SEF.

Tradeweb says it has executed swap trades on its electronic platform that get delivered to central clearing houses within a matter of a few seconds.

Ray Kahn, managing director at Barclays Capital, says the industry needs to make sure it is ready for a pronounced jump in volume.

Since 2010 the bank has cleared more than $4tn of over-the-counter derivative trades, a market share of 70 per cent to date, with clients clearing via the three major clearing houses.

Mr Kahn adds: “The industry needs to ensure that the operational infrastructure can handle material clearing volumes.” Beyond just initially clearing a swap, he says the bigger challenge for brokers will be managing the daily life cycle requirements of swap portfolios, including changing margin requirements as prices move.

Not everyone believes swaps will become widely traded, hyper-liquid instruments like futures. While electronic trading could allow smaller trade sizes and increase volumes, the scale and complexity of collateral requirements at the clearing houses could instead mean fewer players taking bigger positions that could be netted off against each other.

Michael Davie, chief executive of LCH.SwapClear, one of the three big clearing houses, says: “We have to be able to support either or both. It is far too big a bet to decide that the market will evolve one way or another.”

As SwapClear’s experience shows, the regulators are pushing the industry at a fast clip. The company has historically cleared swaps in batches of 15 minutes, but while it has been given a deadline extension to comply, the CFTC has not backed down from its insistence on near real-time clearing.

It has not given any ground, either, to critics of Dodd-Frank who warned that the clearing houses could become “too big to fail”, since they will now hold the risk of defaults by the Lehmans and AIGs of the future.

“It is all about how you manage that risk, and that puts the onus on the central counterparties to have extremely high tolerances, and to have robust risk management principles around what they do,” says Mr Davie. “I liken us to air traffic controllers. Hopefully, if they do their job right, no one ever thinks about them. Much like them, we have to be highly regulated, have very strong risk management and be exceedingly good operationally – and that’s just the standard for being OK."