Looking Beyond Regulatory Deadlines towards Greater Market Efficiency

The pace of derivatives reform in the U.S. is accelerating, and with new SEF rules hitting the Federal Register on June 4th, “now is not the time for conjecture about who will be left behind as markets evolve. It is time to develop best practices and winning strategies to adapt,” says Tradeweb CEO Lee Olesky.

With the arrival of Category 2 clearing, the CFTC now requires most OTC swaps market participants to clear derivatives trades through a centralized clearing party. The new reform is understandably complicated and poses a range of challenges for swaps customers, especially those who have not yet prepared for the operational overhaul towards electronic execution, processing and clearing of derivatives trades.

And as adoption of e-trading increases, Olesky advocates in a recent op-ed to the Financial Times, that market participants must focus on doing “more business in less time and build scale in the markets where they excel.” Read below for Olesky’s complete contribution to the FT Trading Room on this imperative transition for the industry in a Dodd-Frank world:

Originally appearing in the FT Trading Room on June 7, 2013 (subscription required) 

Beyond the sound and fury of CFTC deadline 

For many US-based traders, Monday marks the beginning of a radical change in derivatives trading.

The next major deadline in over-the-counter swaps market reform will take effect, requiring “Category II” companies such as commodity pools, hedge funds and non-swap dealer banks, to clear derivatives trades through a centralised clearing party.

That is a significant step because there are about 500 buy-side institutions who fall under the new mandate and any hiccup in their ability to trade freely could cause a major drain of liquidity in the swaps market. Cue the panic stricken masses.

According to recent analysis by Tabb Group, 75 per cent of Category II institutions will fail to meet the deadline because they have not taken the necessary operational steps to comply.

Some have not executed legal contracts with derivatives clearing organisations, others have not set up legal entity identifiers and some have flat-out resisted any change to the status quo. As a direct result, the report suggests US swaps trading may drop by about $55tn in notional volume.

While sentiment behind this fear is noble, it might be too early to say the derivatives sky is falling. Central clearing rules are complicated and may pose a threat to liquidity in the short term as we know it, but they are not a surprise. And for those who have lived through the past five years of regulatory reform, the notion of trading derivatives over the phone is evaporating rapidly.

Now is not the time for conjecture about who will be left behind as markets evolve. It is time to develop best practices and winning strategies to adapt.

We know buy-side and sell-side need to reduce costs to trade swaps efficiently in an environment of increased price transparency, clearing and trade processing. Instead of lamenting the headache of making all the systems work, we need to focus on ways market participants can do more business in less time and build scale in the markets where they excel.

There’s an apt example in the recent experience of Category I brokers who, only three months ago, sailed through implementation of their central clearing mandate with not a blip in liquidity. In fact, more than $500bn in notional volume was routed through clearing houses by Category I brokers in the week after the March 10 deadline for mandatory clearing.

How is that possible? Even though the deadline was set, the evolution of this type of swaps trading had been several years in the making. Since launching interest rate swaps and credit default swap indices trading on Tradeweb in 2005, more than 155,000 trades, representing more than $13tn in notional volume, have been executed on our systems alone. And we’re just one marketplace.

The evolution of derivatives to trade on electronic swap execution facilities has been under way for nearly a decade. Will some resist the transition? Probably. Will 75 per cent of Category II buy-side funds suddenly drop out of the derivatives market? Only if they can’t access liquidity efficiently.

If the history of government bond and mortgage-backed security trading is a guide, – transforming into electronic markets more than a decade ago – all market participants eventually realise that when margins get tighter, efficiency is where the profits are.

Many commentators have been quick to gripe that new rules stifle efficiency through extra steps for clearing, collateral management and all manner of operational prep-work. But the truth is that once the initial grunt-work is done, derivatives markets will become more efficient because they too will be electronic.

Fixed income trading and off-exchange derivatives markets have been something of an anachronism when compared with the broader financial industry’s adoption of electronic trading. It wasn’t that long ago that the only way to see prices in the US Treasury market was through green screens.

Should things have stayed that way? I’m sure there are some nostalgic people among us who may honestly say yes. But they shouldn’t drive our guidance on the future of derivatives market structure.

The rate of adoption for electronic trading is compounding. The starting line may be further away for some institutions, but every day we are seeing more clients trading more of their fixed income business. And as we move into a new regulatory regime, these companies are gaining an edge through electronic trading to operate more efficiently. It’s those strategies – not just noise about changing market structure – that must be the focus for institutions vying for the opportunities tomorrow’s market brings.

Lee Olesky is chief executive of Tradeweb Markets