Corporate trading will likely mirror that of credit default swaps and migrate to platforms that allow a more flexible execution protocol than exists in the current two-tiered market structure.
The corporate bond market escaped Dodd-Frank without any meaningful change to the way business is done. Market structure and trading are essentially untouched and won't be directly affected by any significant regulatory burden from the law. While the cash credit markets escaped unscathed, the CDS market did not. CDS transactions will be centrally cleared to eliminate counterparty risk.
The vast majority will be traded on swap execution platforms which will provide centralized electronic execution. Trades will be publicly reported with a slight delay - at 15 seconds or 15 minutes per current proposals. These aspects of the market are pretty much a fait accompli and are accepted as part of the new landscape.
Other details are not so clear. Final requirements for which swaps will initially require clearing are still being worked out. Similarly, SEF execution requirements, access and block trading requirements are being evaluated. Rule clarification in these areas will have a significant affect on derivative execution and will play an important role in shaping overall OTC market structure. Despite the lack of certainty in some areas, the impact on the CDS and credit markets is becoming increasingly clear.
Increased transparency, multi-participant electronic execution, and central counterparty clearing for CDS transactions will have a significant impact that goes beyond the OTC markets and will provide the catalyst for a transformation in corporate bond execution. As the OTC market develops under its new structure, corporates will similarly evolve, and both will likely converge to trade on multi-participant SEF platforms that will concentrate liquidity.
The transparency resulting from CDS trade reporting will be a major contributor toward increased liquidity in the credit markets. It will level the playing field for participants, particularly for single name credits. We anticipate increased activity in switch and basis trading between corporate bonds and CDS, which will lead to a corresponding increase in corporate liquidity that largely parallels that of the CDS market.
The impact should be similar in some ways to the introduction of TRACE and lead to tighter spreads and increased trade volume for both products. Naturally, this will have the most pronounced effect on the more widely traded names and those with higher weightings in the benchmark indexes.
The extent of the impact of SEFs on the market is hard to project, with many requirements still being evaluated by regulators. It is safe to say, however, that it will have a significant impact on CDS execution. It's really a matter of just how pronounced that will be.
At a minimum, it will centralize trading on electronic venues that allow a freer flow of liquidity among its participants. We expect it to go well beyond that and lead to an execution protocol that more closely resembles a central order book for many credit products. SEFs will facilitate a greater degree of customer-to-customer trading, rather than the current two-tiered market structure. Indexes and the "larger" credits will likely migrate to a central order book structure, which we anticipate will ultimately yield better execution, while less frequently traded credits will probably continue to trade by request for quote, auction, or other means.
Corporate bond execution will inevitably move in parallel to the CDS market, albeit under a more fractured structure. Corporates (again, the "larger" names) will be increasingly traded on SEFs alongside CDSs, where the combined volume, transparency, and open market structure should lead to better liquidity in both products. The efficiencies gained through electronic execution, which include speed, convenience, and list trading, should grow to include price, liquidity, and market depth. Voice trading is not dead, but it may be left for block execution or less liquid securities.
Central clearing removes the counterparty from trade execution, which should further enhance execution on SEFs. Participants will have the ability to access a greater pool of liquidity that comes from expanding the available trading partners beyond their current ISDA documented counterparties. Execution will be driven solely by economics rather than credit considerations.
Clearing brings an added cost to the CDS trading. This cost and the necessary collateral involved will make CDS products marginally less attractive when compared with the underlying cash securities. Cash trading volume should increase as a result. The net credit risk transfer should be unaffected, with any decrease in CDS volume offset by an increase in the cash market, particularly in the more liquid securities.
We anticipate that many of the limitations that exist in today's two-tiered market structure, dealer-to-dealer and dealer-to-customer execution will become more pronounced going forward. The Volcker Rule is expected to be a contributing dynamic that will further drive the markets toward centralized electronic execution.
Prohibiting proprietary trading for some U.S. dealers will broadly affect execution in just about every asset class. It is safe to assume that it will reduce the capital committed and risk appetite at effected dealers and force them to utilize more of an agency role for their trading books. In conjunction, non-dealer intermediaries and liquidity providers, hedge funds, and alternative asset managers will play a more prominent role in risk transfer in the markets.
The cost of liquidity will go up for customers since dealers will have little incentive to hold large positions. Transaction size will most likely drop. Customers will be increasingly inclined to manage market risk themselves or through brokers to get the best possible execution. We believe SEFs are capable of offering a model that is well suited for a wider dispersion of liquidity in the markets. They will provide multi-directional trading platforms for derivative products and their adoption should similarly change the price and liquidity dynamics of the associated cash markets.
In the credit markets, the impact of Dodd-Frank will extend beyond its direct effect on derivative products and likely lead to a similar transformation in the execution of cash securities. Tighter spreads, increased volume, and deeper liquidity, particularly among the actively traded securities, will be the byproduct of those factors mentioned above. We believe SEFs will provide centralized electronic trading for both cash and CDS transactions, combining liquidity and creating more efficient execution venues for both markets.
Sean Owens is the Director of Fixed Income at Woodbine Associates, focusing on strategic, business, regulatory, market structure, and technology issues that impact firms active in and supporting global fixed income and derivative markets.Sean Owens is Director, Fixed Income at Woodbine Associates, Inc. focusing on strategic, business, regulatory, market structure, and technology issues that impact firm's active in and supporting global fixed income and derivative markets. View Full Bio