Pole Position in the New Swaps Market

By Adam Sussman, TABB Group

Originally published on TABB Forum 

Over the years, the value of pole position in NASCAR and Formula One races has been on the decline, as winning has more to do with having the right tools and equipment than where you start. The same can be said about the new swaps market. 

Over the past month, the industry has been rightly focused on the complexities, barriers and importance for Category II firms to be ready to clear swaps. However, initial readiness by June 10 is hardly the finish line, and even those in leading positions now could easily fall into the back of the pack. The same holds true for the clearinghouses, trading venues and technology providers that are trying to sell the laundry list of services associated with the overhaul.

On the client side, even if a firm has completed the major steps to being able to clear, it does not mean it is capable of efficiently managing its swaps positions and the related movement of collateral. In other words, being ready to clear by June 10 is not the same as being ready to manage a cleared swaps portfolio.

Some clearing-ready clients will still choose to reduce their swaps activity over the next few months until they have a better understanding of the portfolio, collateral and operational nuances involved. Portfolio margining, collateral management, and safety of initial and variation margin are just three areas that go above and beyond the technical necessities to clear.

Precise and efficient communication with the clearinghouse will be a critical buy-side process that will become more important over time (see: “Swap Portfolios in Transit”). As the buy side looks to terminate, compact and rebalance its swaps portfolio, a single mistake in coding or trade detail could mean that the clearinghouse fails to recognize the true intention of the trade and a sub-optimal margin requirement.

Clearing-ready clients may also scale back their swaps trading until they are ready to clear through multiple FCMs and multiple clearinghouses. TABB estimates that nearly 375 Category II funds will fail to meet the June 10 deadline; but even among those that are ready, how many will have multiple FCM relationships in place? And how many will be able to direct trades from any FCM to any clearinghouse? Reluctance to rely on a single FCM to handle all initial and variation margin may cause some firms to reduce their swap exposure, until they have multiple relationships in place.

Similarly, just because a clearinghouse, trading venue or technology provider seems to be best positioned for success right now, it is hardly a predictor of long-term success. Throughout the entire rulemaking process, we have learned that there is a first-mover disadvantage during this transformation.

The industry has consistently been wrong on the implementation date for the trading mandate. In 2011, in our SEF industry barometer, two-thirds of respondents believed the trading mandates would be in effect by Q1 2012 or earlier. It is also likely that the industry believes that the major changes will take place in the next year. I believe there is a much longer game at stake – that the changes we see this year will only be setting in motion a much greater series of changes.

The uncertainty surrounding the timing and the outcome of the swaps transformation has led to a tremendous amount of jockeying and innovation among the field of contenders. The vertical exchanges are hedging outcomes by focusing on the two core businesses – trading and clearing – but also by focusing on the markets where they are already a formidable presence: CME Group is focused on rates clearing and launched a deliverable swap future (DSF) on interest rates; ICE is clearing credit defaults swap with a plan to launch credit futures. The competition is multi-faceted, with competing contracts on one hand and competing clearinghouses on the other.

Over the past few months there has been an uptick in announcements. The types of announcements that have come out recently have focused on two areas: trading or plumbing. Trading is, of course, the glitzier announcement and the one that has garnered the most attention from the press. Whether it is the various efforts at standardizing interest rate swaps, the launch of credit default futures or the tweaking of existing products, there has been quite a bit of hype in this area, and we do not expect it to calm down anytime soon.

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The other type of announcement is on the plumbing necessary for the buy side to handle a cleared swap environment. On Friday, June 6, Tradeweb announced it has launched a service that allows customers to speed up approvals of swaps before they are executed and sent to the clearinghouse. Without this kind of functionality, a client could be waiting minutes or more to have the FCM/swap broker approve and send the trade along to a SEF for execution.

ICAP and its subsidiaries, TriOptima and Traiana, have also been busy on this front. In May, Traiana announced that an FCM successfully completed production testing of its CreditLink service, a way to manage pre-trade clearing and trading limits with DCMs or SEFs. This solution would also help bring certainty of clearing to the market. Then on Friday, TriOptima announced it will be using data reported to the DTCC’s trade repository to help in the reconciliation process. 

Earlier in the year, TrueEx announced it had developed an electronic communication tool to help the buy side manage its trade communication with clearinghouses and dealers. The tool is designed to help the buy side make sure that when it attempts to terminate, compact or rebalance a portfolio, the new trades being sent to the clearinghouse are sent with the correct information.

Lastly, Clarus Financial Technology announced the release of an application that allows market participants to view the tremendous amount, but little understood, data that is made available by the Depository Trust Clearing Corporation (DTCC) through its Swaps Data Repository (SDR).  

This type of functionality seems more than obvious. But that is the point. How can anyone know how this market is going to play out when the kind of functionality that is taken for granted in mature markets is barely developed for the new swaps world?