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. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio