The Future of Swaps Trading: Are We All Missing Something?

By Radi Khasawneh, TABB Group

Originally published on TABB Forum

The Bank of England’s recent analysis of swaps market structure may miss the fact that coming global regulatory changes will alter flows and liquidity over the next two years.

The implementation of the Dodd-Frank reforms in the U.S. has resulted in a tangible decline in execution costs and disintermediation of interdealer-brokers, according to a report published by the Bank of England (BOE) this week. The flip side of this has been a fragmentation of the market along regional lines, the report claims.

The conclusions of the report, based on data from LCH.Clearnet SwapClear, back up the conclusion of reports published periodically by the International Swaps and Derivatives Association (ISDA) since the advent of swap execution facilities (SEFs). These have shown that moving the most liquid interest rate swap contracts and currencies onto transparent and cleared venues has increased so-called fragmentation – the likelihood that parties in the same region choose to trade with each other (particularly interdealer) has increased. (In fact, the latest ISDA report uses more up-to-date data, for those of you interested in tracking the more permanent trend.) The BOE analysis is supplemented by publicly available Depository Trust and Clearing Corporation (DTCC) data, which does indeed show a growing trend toward cleared contracts overall (Exhibit 1, below).

Source: TABB Group, DTCC GTR

TABB Group has been tracking and covering the evolving swap market story for a while, but the BOE authors have added a new twist: They have put numbers on decreasing transaction costs in the US market since transparency standards came into force. According to their research, execution costs in USD mandated contracts have dropped by $7 million, to $13 million daily, when compared to euro-denominated equivalents in the time period covered (January 2013 to December 2014).

CFTC commissioner Chris Giancarlo, who issued a white paper a year ago criticizing the implementation of swap markets regulation and calling for a reexamination of the Dodd-Frank Execution Mandate, is criticizing the causality implied by the BOE paper. “The reduction in the cost of swaps execution came about through aggressive competition and price discounting in the industry, which is a natural evolution of the market,” Giancarlo told the Financial Times. “Neither Dodd-Frank nor the CFTC swaps trading rules were written with the goal of reducing the cost of trading swaps.”

This is all well and good, but surely a reduction in trading costs and an increase in price transparency and disintermediation are signs of a healthy market? Even more important, how does that square with regional fragmentation and the lack of flow seeking to take advantage of any cost arbitrage (signs of a “sickly” market)? The answer to this seeming contradiction, as ever, appears to come down to the elephant in the room: regulatory uncertainty. Lack of mutual recognition and significant differences in approach have left end users and buy-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 U.S. regulators are finally close to agreeing to “equivalence” in clearing rules and margin and capital treatment for swaps. Veterans of this process could be forgiven for giving a big shrug to this news – there has been a rollercoaster of optimism and pessimism over this for the past two years; but the crucial difference here is that it seems that the U.S. side is expected to have won a long-running dispute to get European recognition for its margin and settlement method (in particular, allowing U.S. T+1 contracts).

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

The pressure on banks is set only to increase, as the Basel Committee for Banking Supervision (BCBS) laid out rules last week to increase capital costs for international banks under a revised framework for its Fundamental Review of the Trading Book, with a reduced but hefty market risk charge for swaps held on bank trading books. There therefore remains a significant liquidity risk that also undermines the apparent healthy reaction of the market to these reforms. Fundamentally, the only thing we can know at this point (ahead of European implementation) is that it would be dangerous to draw strong conclusions before global markets catch up to the U.S.