The CFTC’s rules will have to be carefully calibrated to take into account the nuances of each OTC derivatives market, but once the regulations are finalised, firms of all sizes will have to change their OTC derivatives trading and clearing processes to accommodate the new rule book.
It is very difficult to generalise and speculate on what might happen to OTC derivatives as a whole, simply because the market covers such a wide range of instruments, ranging from liquid, globally traded markets through to bespoke contracts tailored to an individual customer’s investment criteria.
However, even though there are likely to be exemptions and loopholes, the CFTC’s rules will define the future market structure for derivatives, on some level, across the entire liquidity spectrum.
A flood of liquidity
At the most liquid end of the scale, Dodd Frank’s creation of a new category of trading venue—the Swap Execution Facility (SEF)—has the potential to impact interest rate and credit derivatives in the same way that Regulation ATS changed the equity markets back in 1997.
Reg ATS helped to stoke competition for equity order flow execution, which in turn prompted technological innovation in the form of Electronic Communication Networks (ECNs), lowered transaction costs, narrowed spreads, increased transparency, launched new trading strategies, and exponentially increased order, quote, and trade volumes.
For the most liquid and standardised OTC derivatives contracts—including certain interest rate swaps (IRS), credit default swaps (CDS), index, blue-chip corporate and sovereign issues—we see a similar scenario evolving, with Dodd Frank promoting transparency, reduced transaction costs and – over time – prompting demand for low latency connectivity and trading systems similar to those used in equity and exchange-traded derivatives markets today.
These factors would also attract new forms of liquidity, with high frequency liquidity providers that have sharpened their teeth in equities and exchange traded derivatives already studying possible opportunities in the swaps market. Yes, High Frequency Trading will invade the OTC derivatives market in the not-too-distant future!
Combining increased transparency with lower transaction costs would also enable a wider range of stat arb strategies, not only within the same asset class (eg. trading single name/s against CDS indexes), but also on a cross-asset basis, as investors seek to develop strategies to trade across companies’ capital structure, for example, by studying CDS spreads, equity and bond prices for a single issuing entity to identify temporary divergences that could be arbitraged away.
While previous efforts to trade CDS on-exchange were unsuccessful, those efforts did not have the regulatory mandate we have today, making this go around a near-certainty. And if standardised, liquid OTC derivatives do trade successfully on exchange-like facilities as we expect—whether via an order-driven or RFQ trading model—the swaps market will become a lot more accessible to investors – individual and institutional alike.
Less liquid instruments
Beyond the most liquid end of the OTC derivatives market is a whole host of instruments that will never be suited to order-driven trading simply because they are non-standard and illiquid in nature. But that does not mean they will fall outside the scrutiny of the rule makers.
It is expected that the new rules will encourage more competitive pre-trade price discovery mechanisms and post-trade transparency across the board. These rules will have to be carefully calibrated to ensure that any obligation to seek out the best price for a trade is weighed against the risk of information leakage from shopping around too much.
Irrespective of the rule details, trading counterparties will need a communications platform that allows them to securely exchange information and which is sufficiently flexible to support the complex message types required for dissemination of OTC derivatives data.
Such a platform also needs to accommodate new requirements both for pre-trade (bilateral and multilateral communication of RFQs, IoIs, quote and order messages etc.) and post-trade workflows (clearing, settlement and reporting—including regulatory reporting).
For trades that are not eligible for central clearing, regulators are also likely to demand that positions are valued more frequently, using independent providers of valuation services to ensure counterparties are accurately marking their positions to market and managing risk exposures.
Rob Hegarty is managing director, Global Head of Market Structure, Enterprise, at Thomson Reuters