The industry looks like the Scarecrow from "The Wizard of Oz": pointing every which way with no clear direction. Between Dodd-Frank, the SEC, the IIROC's dark pool proposal and the MiFID Review, it seems as if there is no clear global (or even local) consensus on market structure, trading practices or participant obligations. Meanwhile, the economy remains challenged.
Still, the global equity markets should have a good 2011. The credit crisis has been behind us now for three years, companies are sitting on cash, a Republican win spells gridlock in D.C., and the Fed's second round of quantitative easing, or QE2, foretells a depreciating dollar that will push investors out of debt and into equity vehicles.
But while the market may be in good shape, between Canada proposing dark pool price improvement, turmoil in Europe, pressure on all off-board trading, and the SEC seemingly focused more on Dodd-Frank than market structure, the world's equity market regulators may be going in different directions. Nonetheless, the U.S. equity market is likely to maintain its current trajectory.
The SEC has been pro-broker and pro-market center competition, and the regulator has worked for years to eliminate the barriers between market makers and investors. To radically move away from this by implementing rules that will slow down the market, create market maker "incentives," or make it more expensive for individual investors to trade would be an admonition that the commission was wrong or that competition is bad. The best we will see is a finalization of circuit breakers -- or, more likely, a migration from circuit breakers to limit-up/limit-down rules that will not shutter the market in the event of an aberrant, fat-fingered order.
Eye of the Storm
But while equities will be put on the back burner, the U.S. is the eye of the derivatives twister. The migration of the OTC derivatives market to exchanges/Swap Execution Facilities (SEFs) will be a once-in-a-lifetime opportunity both to build a market from scratch and to lobby regulators to slant it in your direction. High-frequency firms, backed by prime brokers and custodians, will push to lower the entry barriers, while the traditional powerhouses will try to keep it closed.
The ultimate truth is likely to fall somewhere in between. The newer entrants will get their market, as regulators and legislators are bound to it; but it may not be the market they wanted. Unless end users, which have been exempted from central clearing and SEF trading rules, are forced into the new market, the swaps market likely will bifurcate.
Pushing end users into the new infrastructure would force them to put up billions if not trillions of dollars in margin. This will keep the traditional customer business where it is today -- as large, illiquid transactions done through large dealers on a bilateral basis. While this business may be centrally cleared and reported to reduce risk, it is unlikely that the business will open or shift to a completely new structure.
While the traditional business may stay in dealer hands, the OTC derivatives market increasingly is dominated by non-dealer financial firms, such as asset managers, hedge funds and insurance companies. They currently make up 51 percent of the market, which is up from about 40 percent in 2008. This market will be the most likely to migrate to exchanges/SEFs. It will be comprised of the most liquid products and revolve around benchmark dates and structures, and it most likely will be supported by proprietary trading firms, hedge funds and asset managers of all stripes.
While the survivors of 2010 are thankful to be left standing, I am optimistic about 2011. The equity markets will do well, and the equity market structure, at least in the States, will be quiet.
OTC derivatives structure and reform will suck all of the air from equities, as the derivatives business experiences a battle of epic proportions. And while quiet on the equity front may not be good for change agents and technology vendors, it may be the best thing for the market, as every once in a while it is nice when the house stops spinning and finally lands.
Let's hope it will be on solid ground this time -- whether it's in Kansas or Oz.Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio