While most capital market players are struggling with being able to comply with the Dodd-Frank trading requirements, a few are working on turning the impending market changes to their advantage.
In particular, under Title VII, firms are working to fill the new roles of clearing agent, swap execution facility aggregator and SEF market maker, and are building capabilities in order management, cash and collateral management and customer reporting. Under the Volcker Rule, the details for which are less developed, firms are working to fill the gaps in underwriting and market-making that will result if some banks get out of those businesses.
For market participants wanting to capitalize on Dodd-Frank, certain decisions need to be made, and, based on those decisions, additional steps need to be taken.
The Decisions
Title VII
- What role do you want to play in trading?
Firms that have been dealers in over-the-counter derivatives need to determine what role they will be playing in the cleared space. The roles of upstairs dealer, SEF aggregator and SEF market maker have different profit models, different value propositions and different technology requirements. It is unlikely that any firm will play all three roles, so this decision is an important one. In making that decision, firms will need both a competitive assessment and some form of customer survey. Depending on how the “made available to trade” rule plays out and how many products remain in the uncleared space, some dealers may want to concentrate their efforts there, leaving the listed market, with its narrower spreads, to others.
For firms that have been customers, the major question is whether to join one or more SEFs or rely on brokers for trading access. That choice will largely depend on the type of OTC derivatives they will utilize (mostly standardized vs. mostly not), whether most of the trades will be end user exempt and their expected trading volume.
- What role do you want to play in clearing?
For dealers, the big question is whether to become a clearing agent or a give-up dealer. This decision will be heavily impacted by decisions made on trading roles. For example, combining the SEF aggregator role with the clearing agent role will dictate one kind of customer relationship (and probably organizational structure), while combining SEF market maker and give-up dealer will dictate a very different kind. And firms that concentrate on the uncleared product set will have yet a different business model.
For customers, the first question is whether to self-clear or use a clearing agent. Like the trading decision, this one is dependent on the primary products used and the variety of instruments. Customers who concentrate on a few cleared products, where membership in one DCO will work, have a very different decision matrix from customers who use a variety of products, many of which are uncleared. If the choice is to use a clearing agent, the next decision is whether to concentrate the business in one or two clearing agents or spread it out. Cost efficiency may argue for concentration, while risk management may argue for dispersion.
- How will you handle reporting?
For dealers, this is a third-level decision, based largely on the two previous ones. Since all regulatory reporting for cleared trades will be handled by the SEFs, dealers will need to decide how they will handle reporting for uncleared trades. For trades done under an end user exemption, there is additional regulatory reporting and dealers will need to work out with their customers whether that function is a value-added service. At the same time, customer reporting, while not mandated by DFA, will be an important competitive offering, so clearing agents in particular will need to design efficient, useful and flexible tools for that.
For customers, the major question will be whether they will fall into the category of major swap participant (MSP). If so, there are additional reporting requirements that customers may want the clearing agent to handle, if they use one. This will be a particular concern for institutional asset managers since the MSPs in their case will be their clients. MSP reporting may be an area where clearing agents market their services directly to asset management clients instead of to the asset managers themselves.