Picking up from last week, I am still wondering if we need to MAT the entire interest rate curve. We’ve addressed transparency. We’ve addressed systemic risk. What are SEF’s all about?
My belief is that the G20 and Dodd Frank want to address “fairness”. There is a perception of an unequal playing field, and the big banks these days take the brunt of it. The credit crisis, LIBOR, London whale, etc, etc. Every day, some bank somewhere didn’t do something right. Banks are the pin cushions of regulation today.
THE PROS
Would anything be better if SEF’s handled 100% of OTC swaps?
Pricing. The theory goes that more market participants providing liquidity in a many to many marketplace will improve pricing. Increased competition will almost accomplish this. And don’t forget that some of the new liquidity providers today can ONLY trade on SEFs and DCMs (as floor traders). So if you subscribe to the many-to-many or all-to-all paradigm, it has to be on SEF.
Liquidity. Liquidity should also improve. While depth of the market could improve, SEF’s should also be able to more readily construct prices for synthetic positions. In theory if you need a price for a 5/7/10 butterfly, you could discover the price by aggregating 5/7 and 7/10 curve trades in the appropriate size. While of course possible now, the more data points the better.
Regulation. One reader pointed this out to me. How would the regulators ever implement regulations like proving best execution, if nothing is on-screen and hence not auditable? The theory goes that once you get everything on-screen, even if only RFQ, that is a first step to the pre-trade transparency required to regulate the execution of derivatives better. Granted, this assumes more regulation a good thing.
THE CONS
Those might be good, but what gets worse?
Cost of being connected to SEFs. There are massive costs associated with getting ready for SEF execution. Rulebooks need to be read and plumbing to the desired SEFs need to be put in place. And what if you find out a year later that you have chosen the wrong SEF? Not to mention these rulebooks change frequently. To keep up with all of the combinations of swaps that can be traded, banks are being forced to upgrade infrastructure with every new release of each SEF. Case in point, even after the the expiry of some no-action relief, there have been complaints of not being able to execute some MAT/non-MAT curve trades (eg 10s v 11s) or non-benchmark UST swap spreads. It requires constant investment in upgrades. All of these go towards the ongoing new cost of managing your SEF readiness.
Fringe benefits. Direct derivatives execution is a service provided by a bank which can afford the luxury of other bank services. The theory goes that by executing their trades with a preferred dealer, they receive preferential pricing and treatment on research, news, issuance, tickets to the Super Bowl, etc.
Information leakage. Every time a large trade gets quoted, there is some information being disseminated to the price making parties. There is a certain symbiotic relationship here between banks and buyside. Information is leaked from the buyside to the bank, and bank is able to deliver good pricing. By breaking this down and forcing an RFQ to 3 banks will simply increase the amount of leakage which should ultimately impact the firm’s ability to execute in any size.
While these are valid cons, they seem to be actively being addressed. Agency execution firms are addressing SEF-connectedness and costs. And many will claim that both banks and buyside have already decoupled the fringe benefits as banks seek to be compliant, and buyside seek best the best products based on merit.
So whats the issue?
THE REAL ISSUE
It’s this symbiotic, 2-tier market that is under attack. In today’s market, anything that puts dealers into a position of power comes under vast scrutiny. Look no further than LIBOR and Gold fixings. Dealers are being blamed for everything, so the easiest solution is to take away their tools.
WHO ARE THE WINNERS AND LOSERS
I’ve been given some estimates on the number of banks providing liquidity into the SEFs. One source estimates that within the next 3 years, this number will more than halve, as European and Canadian banks realize that the revenues in this business do not justify the costs. This would of course run counter to the intentions of providing a more fair marketplace with more liquidity providers. It’s great to have many-to-many, except when half of the guys leave the room.
So, I began documenting the entire ecosystem of the OTC market to look at potential winners and losers. In short, everyone is a potential loser. Banks lose. Large buyside lose. Given the costs associated with regulation, smaller firms even lose. As usual, the only big winners are consultants, vendors, and lawyers.
SO WHAT TO DO
First, I think we need to stop the witch hunt on banks.
But balance that with moving the industry forward.
We need some time. Let the new liquidity providers get up and running. Give more time to the buyside to dabble in SEFs. Allow the agency firms on the execution and post-trade side to get infrastructure bedded down. Allow time for the industry to innovate.
With that said, I’m in favor of keeping the foot on the pedal, just at a measured pace. The best innovation happens in times of pressure. I think we can justify slowly eating away at the universe of MAT products. It’s up to the SEF’s themselves to justify the need and validity for more MAT-able products. I believe it is justifiable. And I expect to see it, and will support it if it’s phased in over a time period that allows firms the time to innovate solutions.
