What is a swap? It's a small word in a big market. And it took only two years and 585 pages to define. It's been nearly two years since the Dodd-Frank Wall Street Reform Package was introduced and the recent announcement on July 10, 2012 by the Commodity Futures and Trading Commission (CFTC) makes clear what a swap is and how these rules apply to them.
The reform package is a paradigm shift in the market structure for the OTC derivatives market whereby requirements include eligible swaps being cleared through a central clearing facility (CCP) and predominately trading on a Swap Execution Facility (SEF).
Currently both buy-side and sell-side desks are scrambling to get solutions in place to meet the new requirements. All the major players recently involved in the electronic trading and straight-thru-processing (STP) of fixed income securities, such as Bloomberg, Tradeweb and Market Axess, have already submitted registration to become SEF's and many additional players are ready to enter the race as well.
Swap Dealers Have Their Own Race to Run
Another outcome of these newly defined rules requires approximately 200 Swap Dealers to now register as a Swap Dealer with the National Futures Association in the fall of 2012. The first hurdle is a 40-page online form to fill out for provisional approval to continue acting as a Swap Dealer. For Swap Dealers above the $8 billion threshold (firms conducting swaps or derivatives with a notional value of $8 billion a year as defined by the CFTC and SEC), registration presumably is a no brainer. For those on the cusp, however, registration is a big decision without knowing the capital, margining, Volker Rule and other key requirements. Some dealers with under the $8 billion threshold may feel the need to register just to be on the playing field of registered Swap Dealers.
Let's shift gears to some of the potential new workflows that are around the bend. Currently investors query the street or peruse dealer runs for price discovery and execution. The new path will introduce sending eligible orders to an SEF dealer where the typical RFQ process will ensue. A newly created entity, Swap Data Repository (SDR), receives the swap information and the SDR is mandated to report transaction execution levels to the market in close to real time. Once a trade is affirmed it will be sent down to a central clearing facility.
The Race Gets Interesting
Investors will have to potentially post margin at multiple CCP's. It's still unclear at present about the interoperability between the multiple CCP's with regards to margin and fungibility of the contracts.
The Bank for International Settlements (BIS) recently published a working paper that lays out the framework for calculating the costs of margins on the G14 dealers, estimating it could cost $100 billion during high volatility periods for swap margins.
So what about collateral? There is currently a squeeze on what is acceptable collateral in today's volatile trading environment. This could make maintaining collateral an expensive proposition. As we know, long gone are the days where there was plentiful high-grade sovereign debt available.
Meanwhile, on the sidelines
Early in the race, there was confusion over whether or not dealers would be able to offer discounted clearing services to win swaps execution flow. Buried as a footnote in the final rule 'Swap dealer and major swap participant recordkeeping, reporting, and duties', the CFTC quietly revealed that it "generally would not view as 'improper' making available discounted clearing services in connection with trading activities, provided that the business trading unit personnel comply with applicable prohibitions and restrictions on their interactions with the clearing unit."
Initial intent was to establish firewalls between research and trading and between clearing and trading. The inclusion of this footnote appears to circumvent the need for any such firewall. As a result, large swap dealers can now leverage clearing business to win execution flow.
No More Procrastinating - It's Go Time!
At the end of the day, what are the opportunities and challenges that lie ahead? Regulators hope for increased trading volumes, more pricing transparency, tighter bid ask spreads, global market expansions and use of electronic trading platforms which allow STP for swap transactions. This should result in fewer trade errors, faster settlement and better look thru to risk and exposure.
But as we all know, with any significant change comes the law of unintended consequences. Case in point would be to look at the recent US Equity markets high-frequency trading issues.
The clearing fees and collateral requirement expenses, which right now no one has a good estimate of, could drive investors to bespoke instruments that would not be centrally cleared. Reporting of trade levels could harm liquidity and overly restrictive regulations could drive business offshore to friendlier venues.
End users of swap transactions face a delicate balance between the goal of reducing systemic risk and increasing transparency versus the risks of diminishing liquidity and increasing transaction costs for their hedging and investment purposes
Ultimately, investors will determine what type of instrument best suits their hedging and investing needs. Until that time, on your mark ... get set ...
Bob Holland is senior product manager for Linedata Longview Fixed Income.