Lawmakers intended to shore up risks to the nation's financial system with the Dodd-Frank Act, but sources say the law could make over-the-counter derivatives trading more complicated — and more expensive — for both dealers and the buy side.
In a bid to prevent catastrophes such as Lehman Brothers' $9 trillion interest rate swap default in 2008, lawmakers mandated that OTC derivatives trades be conducted out in the open, on swap execution facilities, or SEFs. Swap trades traditionally have been negotiated and executed privately between counterparties on a bilateral or trilateral basis. In fact, before Dodd-Frank, a significant number of OTC swaps deals were still conducted over the phone, though a growing number already were moving to electronic markets such as Tradeweb.
Once regulators finish determining how this market will function under Dodd-Frank and the law's new requirements take effect, however, firms will be able to execute derivatives trades by accepting bids and offers from multiple participants on SEFs. In addition to bringing the $600 trillion OTC derivatives market out into the open, SEFs also are intended to ensure a full record and audit trail of most transactions, while making these opaque instruments more transparent on a pre- and post-trade basis.
If the law functions as intended, participants will get a fuller view of the actual value these formerly OTC assets hold in the broader market, rather than simply relying on their dealers to name the price. In theory, moving derivatives trades onto SEFs also will increase the level of liquidity flowing throughout the marketplace, while lowering transaction costs in the process.
More Difficult Than It Sounds
But in practice, experts say, things won't be so simple. For starters, the market is likely to fragment since firms will look to transact in liquidity pools where they can compare and trade similar derivatives contracts, according to Zohar Hod, head of the Americas division at OTC derivatives pricing and valuation firm SuperDerivatives.
"A vanilla swap versus another swap might have similar terms, but it's not something you can literally compare apples-to-apples," Hod says. "The problem, in a word, will be finding liquidity, because there are so many different contracts with so many different terms. Finding the right massive amounts of liquidity is going to be a major cause for fragmentation."
Meanwhile, Dodd-Frank also requires that all swaps trades be cleared through central counterparties (CCP), which will assume most of the risk on these transactions. (If one of the counterparties were to default, the deal would be insured by the CCP, which raises money by collecting margin payments from firms that trade derivatives.) As a result, in addition to figuring out on which SEFs to execute, buy-side firms also will need to determine where to clear their trades and which algorithms to use to lower their initial margin payments, Hod relates.
"Now you need to decide where you're going to execute your trades, and there are so many places to do it," he says. "Then each place clears with another clearing agent and through another prime broker, giving the buy side a huge headache."
According to Hod, "Some buy-side firms will decide that in order to standardize things, 'Whatever the margin is going to be, we're going to do it with one liquidity pool or one SEF.'" But this strategy, he notes, could cause firms to miss out on the best liquidity sources. Instead, Hod says, he envisions a scenario in which a firm with deep pockets, such as the asset manager BlackRock, decides to build a tool that can aggregate the best liquidity sources into a single view.
The Need for Aggregation Tools
Tabb Group analyst Kevin McPartland agrees that liquidity aggregation tools will become a necessity, but he contends that dealers are the ones that will be spending heavily to build them. In a recent report, McPartland argued that swaps dealers are preparing to spend a combined $504 million to create, implement and market the aggregation platforms that the buy side will need to trade swaps effectively.
"Whether there will be three or as many as 10 SEFs per asset class remains unclear, but finding the size you need at the right price will become less about who you know and more about the quality of your aggregation technology," McPartland wrote in the report. "The need for SEF aggregation is serious, and it's not going away."
But unlike liquidity aggregation tools for assets such as equities or foreign exchange, the technology for swaps will be much more sophisticated and substantially more difficult to build, the report added. And costs will be a concern, both for the dealers that will be creating these systems and for the firms that are looking to send orders to a variety of SEFs in a newly fragmented market.
"Clearly there's a big cost to both dealers and the buy side to route their orders to lots of venues," says Jeff Gooch, chief executive of MarkitSERV, a firm that specializes in trade confirmations. "And for the optimization technique — particularly in the equity markets — the amount of money that's spent on that technology is enormous."
Gooch says he believes the derivatives marketplace ultimately will function much like the equities world, in which smart order routers, algorithms to optimize executions and aggregators are the required tools of the trade. Yet these items all come with a price tag, he points out. "That cost must get back to people somehow, whether they rent it or it gets put into bids and offers," Gooch predicts.