As 2013 draws to a close, I thought I would summarise what has been a momentous year in the history of the Swap market.
Five years on from the 2008 Financial Crises, we finally saw the implementation of major regulatory reforms. This article will look predominately at the US Dodd-Frank Act reforms in 2013 and make a few projections for 2014.
Trade Reporting
We started the year with the implementation in the US of mandatory trade reporting and real-time public dissemination of Swaps and other derivatives. For the first time, anyone was able to see on any given day, what products trade, what price they trade at and at what volume. I cannot overstate the fundamental nature of this change; we have moved from a market where transactions were private and a few privileged firms had a deep insight, to a market where there is transparency for the good of the whole market.
For more on Trade Reporting, look back at our 2013 blogs on this topic.
Mandatory Clearing
While Swap Dealers have been Clearing Swaps for years using LCH SwapClear, in 2013, we had three deadline dates in March, June and September for mandatory clearing for dealers and clients. These were successfully met, with no noticeable fall in volumes or migration of trading from OTC Swaps to Futures. Both CME and LCH SwapClear are now processing large numbers of Swap transactions, in an automated daily process requiring all firms to post initial margin and variation margin. Surely a much improved business process than the prior manual and firm to firm ISDA CSA process.
For more on Clearing, look back at our 2013 blogs on this topic.
Electronic Trading
By the October 2 deadline, we saw 18 firms register their interest with the CFTC to operate Swap Execution Facilities and commence trading. Significant volume is being transacted on these platforms, operated both by incumbent Inter-Dealer-Brokers, established Venues and New StartUps. Indeed on an average day 60% of USD IRS volume is transacted on SEFs. While the rules on Impartial Access, Cross-Border Jurisdictions and most importantly MAT (make available to trade) rules are yet to fully kick in, we know that from mid-Feb 2014 a number of common Swap trade types will become mandatory to trade on a SEF.
For more on SEFs, look back at our 2013 blogs on this topic.
Volcker Rule
Last but not least, on December 10th, we had the adoption of the Volcker rule, a key provision of the Dodd-Frank, designed to separate and limit proprietary trading from client trading. The media has been full of stories of the impact of this on the earnings of Swap dealers, with mixed views on whether firms have already moved out of these activities by spinning out or closing businesses or are yet to feel the impact.
See WSJ – Volcker Rule Challenges Wall Street and BBG – Wall Street Exhales as Volcker Rule Seen Sparing Market-Making
What Can We Expect in 2014
In the US, the new market structure is largely complete, battle-lines have been drawn and we will soon see which firms gain and which firms lose.
- Will Inter-Dealer-Brokers maintain their profit share or will new venues make significant gains?
- Will Swap Dealers see lower profits through impartial access to pricing for all?
- Will volumes increase with more trades in smaller size?
- Will volume and liquidity decrease as trading moves to Futures?
Your predictions are as good as mine.
All we can do is wait to see the data.
What we do know though, is that in many ways the baton of reform will pass from the US to Europe and Asia.
The European EMIR and MIFD directives will come into force with the start of mandatory reporting in February 2014 and subsequent dates for mandatory clearing and trading on Organised Trading Facilities (OTFs).
Lets hope with hard work and initiative, the the industry is up to the challenge of meeting these dates as successfully as it was in meeting the 2013 ones.
Further afield, we see Trade Repositories and Clearing Houses, blooming all over Asia, with Tokyo, Singapore, Hong Kong and Australia, either already live or rolling ahead with implementation plans.
Longer Term
Of more importance than 2014, is the market structure not in 2014, but in 2018.
One key characteristic is whether the Swaps market will be Horizontally Integrated or Vertically Integrated like the Futures markets.
Despite the regulatory framework of open and competitive markets, so a product can be traded on one venue and then cleared on another, we now see in Futures a few large firms that are vertically integrated and national champions. CME, Eurex, ICE each trade and clear specific products in which they have all the liquidity.
Despite their privileged position, large profits and market capitalisation (CME $25b, ICE $23b), we do not see the same sort of press coverage as we get about Investment Banks and their out-size profits ($44billion is an oft-quoted number).
While it is true that regulators did not find cause to implement significant reforms for Futures and Exchanges would say they are capable of efficiently processing massive volume, we cannot afford to be complacent.
After-all in the same way that tax payers money is at stake as the lender of last resort to failing banks, tax-payers are also on the hook as allowing a major Exchange to fail would be catastrophic.
This is more of concern, if the Swap market follows the Futures market, with the same players capturing all global liquidity in a specific product. Imagine if CME captures USD Swap trading and clearing, alongside its Futures franchise, imagine if Eurex captures EUR Swaps alongside the Bund Future and ICE does the same for shorter maturity EUR & GBP Swaps.
Final Remarks
The question of whether SEFs, CCPs and SDRs will be owned by different firms and able to operate efficiently and profitably or whether they will end up being vertically integrated into Futures Exchanges is an important one for the industry.
It is important for systemic risk, market liquidity, price transparency and cost efficiency.
In my view the forces of competition and openness, with laws set by sovereign states are paramount.
Whether that means Swap markets and Futures markets merging, only time will tell.
I wish you all an interesting and productive 2014.