It’s no longer business as usual in the world of interest rate swaps. Electronic trading and central counterparty clearing are transforming the broader OTC derivatives market, as buy-side participants seek the ability to improve transparency and meet new regulatory requirements while continuing to trade swaps in order to hedge interest rate movements.
Meanwhile, banks are making provisions for the upcoming regulatory changes and adapting their business models to enhance customer loyalty and facilitate increased levels of trading with the buy-side.
Recent regulatory changes in the US are driving execution of swaps to much more tightly regulated platforms, including exchanges and swap execution facilities (SEFs), with European markets expected to follow. This new regulatory structure is causing substantial shifts in the overall swaps market structure, and introducing a plethora of new challenges for market participants.
Will these changes result in such major shifts in behaviour that current relationships are no longer relevant, moving the market rapidly towards an all-to -all order-driven model?
The Buy-Side Challenge
The rules set to be implemented as a result of both the Dodd-Frank act in the US and EMIR/ MiFID II in Europe will force buy-side institutions to evaluate different options for execution and clearing, and put in place new arrangements, procedures and documentation with trading venues and clearing houses. This is a substantial piece of work and as such could have major time, cost and efficiency implications.
Under the new regulations, all transactions will have to be routed through regulated platforms, subjecting them to pre- and post-trade disclosure rules, including specific requirements relating to block trades. Those disclosures could make it more difficult for a market-maker to hedge client business and the end result, many dealers argue, will be a higher proportion of smaller trades, which means an increase in reporting workload for buy- side counterparties.
There will also be costs involved with setting up regulatory-compliant arrangements for trading and clearing swaps, as a result of higher legal fees and staff costs involved with reviewing, understanding and negotiating the new swap arrangements and documentation.
For cleared swaps, each counterparty will be required to post both initial and periodic margin collateral, with a range of options relating to levels of segregation. For non-cleared swaps, there will be costs involved with the reporting requirements of utilising the commercial end- user exception, and it is widely expected minimum collateral posting requirements will be imposed on all derivatives contracts, regardless of whether or not they are cleared.
The Sell-Side Challenge
Optimizing customer service in the derivatives space has become a key focus in recent years, as clients look for differentiating factors in an increasingly cost-sensitive environment. As the interest rate swaps market continues to evolve, banks are seeking innovative solutions to add value and stand out from the crowd to attract and retain clients while complying with new and emerging regulations.
The challenge is finding a market structure that can balance banks’ competitive drive for flow, is consistent with the new regulatory and capital landscape, and lets participants access the swaps market in a manner that suits their unique trading requirements.