Where's the Arb? Regulatory Fragmentation Breeds Uncertainty, Opportunity

By Radi Khasawneh, TABB Group

Originally published on TABB Forum 

Regional implementation of mandatory clearing and swaps trading reforms means differences in regulatory regimes could make all the difference in the race for alpha.

The much-delayed finalization and implementation of Europe’s Markets in Financial Instruments Directive and Regulation (MIFID II) means that it is now possible to make direct comparisons on the swap trading environment on both sides of the pond. In the absence of any defined cross-border recognition between the US and Europe (as has been planned), market participants are left in a preliminary limbo, forced to navigate an increasingly fragmented and uncertain environment.

TABB Group’s recent report, “European Swap Trading: Slow and Steady Wins the Race?” highlights the main areas of difference across these regimes. In essence, there is a view that, despite taking a much more complex and tortuous route, the optionality embedded in the European approach – with market participants able to choose among various venues and trading protocols – may in the end become an advantage.

European implementation will not be completed until January 2017 (see Exhibit 1, below), but the interim period has been marked by an increase in fragmentation – both in terms of trading flows and the infrastructure required in each region. For example, there are now 22 trade repositories for interest rate swaps globally. Six of those are in Europe alone (the figure includes regional entities set up by firms headquartered elsewhere).

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Source: TABB Group 

This creates a unique data and consolidation challenge for market participants, and it has been highlighted as a key area of concern. In November last year, David Wright, secretary general of the International Organisation of Securities Commissions (IOSCO) complained about the impossibility of getting an aggregated risk picture from these different regimes and data systems. This high-level surveillance problem has led independent companies to step in and provide market participants with the ability to do this tracking themselves.

Meanwhile, trading flows have become increasingly fragmented and regionalized. Exhibit 2, below, shows the decline in uncleared Euro-denominated interest rate swap volumes in the US, and a more general downward trend in their use. ISDA data based on LCH.Clearnet interdealer volumes has shown a strong preference for European banks to trade such contracts bilaterally.

While this fragmentation continues, it is natural that market participants would look to compare regimes and retrench until compliance and surveillance issues are sorted and harmonized. That is all well and good; but the fact is, the market is undergoing a historically unprecedented shift out of over the counter (OTC) contracts and into centrally cleared ones – it will take a long time to sort through the mess.

Exhibit 2: Evolution of Cleared vs. Uncleared IRS Swap Markets by Currency 

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Source: TABB Group, DTCC 

There are many moving parts that will affect the overall picture; it ultimately will be more complicated than simply declaring winners. In the latest reminder of the ongoing regulatory disharmony, this week the UK Financial Conduct Authority warned that the net effect of European proposals to impose position limits and caps on commodity positions went far further than the US equivalent.

Each step will be scrutinized, but the uncertainty is the cause of the present fragmentation of swap markets. TABB Group will this month publish an in-depth analysis of post-crisis swap flows globally (please contact us for more information), but the current situation creates an opportunity for sophisticated buy-side firms to act in their own strategic interests.