Future of Swap Trading: Are We Missing Something?

By Radi Khasawneh, analyst at Tabb group

The implementation of the Dodd-Frank reforms in the US hasresulted in a tangible decline in execution costs, and disintermediation ofinterdealer-brokers, according to a report published by the Bank of England(BoE) last week. The flip-side of this has been a fragmentation of the marketalong regional lines, the report claims.

The conclusions of the report, based on data from LCH.ClearnetSwapClear, back up the conclusion of reports published periodically by theInternational Swaps and Derivatives Association (Isda) since swap executionfacilities (Sefs) came into being. These have shown that moving the most liquidinterest rate swap contracts and currencies onto transparent and cleared venueshas increased so-called fragmentation – the likelihood that parties in the sameregion choose to trade with each other (particularly inter-dealer) has increased.(In fact, the latest Isda report uses more up-to-date data, for those of youinterested in tracking the more permanent trend.) The BoE analysis issupplemented by publicly available Depository Trust and Clearing Corporation(DTCC) data, which does indeed show a growing trend toward cleared contractsoverall.

Tabb Group has been tracking and covering the evolving swapmarket story for a while, but the BoE authors have added a new twist: They haveput numbers on decreasing transaction costs in the US market since transparencystandards came into force. According to their research, execution costs in USDmandated contracts have dropped by $7 million, to $13 million daily, whencompared to euro-denominated equivalents in the time period covered (January2013 to December 2014).

CFTC commissioner Chris Giancarlo, who issued a white papera year ago criticising the implementation of swap markets regulation and calledfor a re-examination of the Dodd-Frank Execution Mandate, is criticising thecausality implied by the paper. “The reduction in the cost of swaps executioncame about through aggressive competition and price discounting in theindustry, which is a natural evolution of the market,” Giancarlo told theFinancial Times. “Neither Dodd-Frank nor the CFTC swaps trading rules werewritten with the goal of reducing the cost of trading swaps.”

This is all well and good, but surely a reduction in tradingcosts, price transparency and disintermediation are signs of a healthy market?Even more important, how does that square with regional fragmentation and thelack of flow seeking to take advantage of any cost arbitrage (signs of a“sickly” market)? The answer to this seeming contradiction, as ever, appears tocome down to the elephant in the room: regulatory uncertainty. Lack of mutualrecognition and significant differences in approach have left end users andbuy-side firms reluctant to trade with counterparties across borders,particularly when the clearing piece of the puzzle is still up in the air.

On Jan 14, press reports indicated that European and USregulators are finally close to agreeing to “equivalence” in clearing rules andmargin and capital treatment for swaps. Veterans of this process could beforgiven for giving a big shrug to this news – there has been a rollercoasterof optimism and pessimism over this for the past two years; but the crucialdifference here is that it seems that the US side is expected to have won along-running dispute to get European recognition for its margin and settlementmethod (in particular, allowing US T+1 contracts).

There are many moving parts to the differences in approach,but could such an agreement actually reverse the fragmentation trend we areundoubtedly seeing at the moment and ultimately lead to much more flexibilityin clearing choices at firms? Should that be the end point, then the periodsince 2013 will be seen as an interim Dark Age before a Renaissance of globaltransparency and price discovery emerges.

The pressure on banks is set only to increase, as the BaselCommittee for Banking Supervision (BCBS) laid out rules this month to increasecapital costs for international banks under a revised framework for itsFundamental Review of the Trading Book, with a reduced but hefty market riskcharge for swaps held on bank trading books. There therefore remains asignificant liquidity risk that also undermines the apparent healthy reactionof the market to these reforms. Fundamentally, the only thing we can know atthis point (ahead of European implementation) is that it would be dangerous todraw strong conclusions before global markets catch up to the US.