A step into the unknown
A key objective of the Dodd-Frank Wall Street Reform and Consumer Protection Act was to tame the US over-the-counter (OTC) derivatives market, seen as one of the main causes of the near-collapse of the global financial markets in the second half of 2008.
As it stands, the legislation includes requirements for exchange trading and central clearing of OTC derivatives, as well as guidelines for data collection and publication of OTC derivatives trades through clearing houses or swaps repositories. All of the new rules have the aim of improving market transparency and allowing regulators to better monitor trading activity.
Migrating a substantial portion of OTC derivatives on exchange will thrust buy-side trading of these instruments into more highly-automated era, but how could this affect liquidity and the associated costs of trading them?
The first factor to note is that electronic platforms for trading OTC derivatives contracts – or swap execution facilities (SEFs), as they are referred to in the Dodd-Frank Act – are not the same as securities exchanges and sometimes the contrast is quite stark.
SEFs are designed to improve the pre-trade transparency of a marketplace that has been historically opaque, largely due to the high degree of customisation it offers. An SEF is required to permit market participants to trade by accepting bids and offers made by multiple broker-dealers. Therefore, a bank or broker system that posts only its own offers for customers to execute against will not qualify. They will also be required to provide timely post-trade data, though the exact nature of this is yet to be defined.
One potential SEF model is the request-for-quote model, in which users define the contracts they require, send a request to multiple providers and receive prices back almost instantaneously. Other possible SEF models include latent order matching, i.e. posting a passive order on a platform that would match against dealer-provided quotes, and voice-broking platforms.
Bringing more transparency to the market in this way will undoubtedly bring greater efficiencies to buy-side traders looking for competitive quotes for OTC contracts. But the scope of the benefits will depend on regulators, who will ultimately decide what gets traded on exchange.
The Dodd-Frank Act states that any OTC contract that is deemed clearable must be traded on exchange. While the Act has handed responsibility for defining ”clearable' to US regulators the Commodities and Futures Trading Commission and the Securities and Exchange Commission, the regulators are unlikely to force clearers to handle products that they will be uncomfortable with. The migration of OTC derivatives is therefore likely to start with homogenous products that can be marked-to-market without dispute, such as credit default swap or equity derivatives products.
When implemented, central clearing of OTC derivatives could drive costs up for investors. Buy-side traders were not previously required to hold any margin at clearing houses for these types of products. These costs could be compounded if different SEFs use different clearers for the same types of contracts.
For instance, while inter-dealer brokers BGC and ICAP – which currently operate electronic trading platforms for derivatives contracts and are likely to apply to become SEFs – use LCH.Clearnet's SwapClear facility for clearing swaps, Nasdaq OMX and the Chicago Mercantile Exchange use their own clearing facilities for their respective swap venues.
But perhaps the biggest issue lies with the Dodd-Frank Act itself. Since it was passed into law in July, the exact rules and functionality governing how a SEF should operate are yet to be defined. Regulators were expected to release draft legislation in December, with a view to finalising the framework for SEF in July, but the House majority claimed by the Republicans in the US mid-terms could yet throw a spanner in the works.
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