Final countdown

IFR Review of the Year 2013
9 min read
mike kentz

The laborious implementation of the Dodd-Frank Act is in the home straight. Some confusion remains as the business of trading swaps on exchanges begins in earnest, but even some former critics accept the regulators have got most things right so far.

The new world promised by the 2010 Dodd-Frank Act for the over-the-counter swaps market is very nearly here. The majority of OTC swaps in the US are now being centrally cleared and the introduction of trading on exchange-like platforms known as swap execution facilities is set to begin in the first quarter of 2014.

After years of complaining about the speedy pace and overly aggressive nature of the chief US swaps regulator, the Commodity Futures Trading Commission, many market participants are actually praising the agency for a job well done.

Now, the CFTC hopes to complete the final leg of Dodd-Frank rule-writing while market participants gear up to do business again, albeit under a completely different guise than in the lightly regulated swaps markets of pre-2008.

The commencement of trading on SEFs this February will be the second true watershed moment of Dodd-Frank rule implementation, the first being the beginning of clearing. Market participants will be mandated to trade swaps on openly accessible screens for the first time ever as the system moves closer to equity markets. Buyside traders can no longer anonymously transact with specific banks for customised swaps but will be forced to route requests to a minimum of two banks before executing, a number that is set to increase in the future.

The SEF framework is meant to level the playing field, not increase market safety and soundness as is often assumed. A review of the swaps markets pre-2008 led global regulators to deem the pricing process unfair and introduce the mandated platforms as a means of mitigating the unevenness.

Banks and interdealer brokers have largely come to grips with the fact that the introduction of SEFs means portions of their profits are likely to be siphoned off by new entrants and emboldened buyside participants, and they know they will have to change their business models to remain relevant.

But uncertainty surrounding the implementation of on-screen trading still dominates the conversation since firms are expected to be fully up to speed with complex SEF rulebooks and an entirely new market connectivity regime by mid-February for standardised interest rate and credit default swaps.

That means 2014 will be a year for shaking out the kinks.

The concerns are being raised from each side of the market, meaning participants will have to show a fair amount of resilience in the first half of the year in order to get through the growing pains.

“It’s very, very clear at this point that customers are having a tough time navigating which SEF to connect to, how to allocate resources, how to function in the new market come February,” said Paul Hamill, US head of credit trading at UBS. “I think when you take what is a relatively joined market in its current form and you fragment it across a number of new intermediary platforms, you’re going to run into some problems.

“Irrespective of whether or not the before-SEF model is good or bad, right now almost every person knows how to transact, and come February we are likely to enter a phase where people do not know how to transact.”

Clearing in place

While compliance with the SEF mandate is just beginning, the central clearing of swaps transactions is now in full swing after a three-part phase-in which began in March 2013. The process has gone smoothly for the most part and many believe markets are safer because of clearing. But others still question the wisdom of pooling all of the market’s swap risk in only a handful of entities.

“I think it is very possible a central clearinghouse fails,” Craig Pirrong, a professor of finance at the University of Houston, told IFR. “I’ve been arguing for a while that a highly interconnected system around a couple of CCPs where the goal is to make a CCP immune to failure has spillover effects. If you build up the levee high in one place, the water may not go there but it’s got to go some place.”

Clearinghouses as the centralised depositories of swaps risk are now designated as too-big-to-fail entities by US regulators. As of now, the biggest such firms in Europe and the US are LCH.Clearnet, CME Group, IntercontinentalExchange, and Eurex.

Market participants often mime the balancing of a scale when discussing whether or not markets are safer and/or fully insulated from another derivatives-fuelled crisis under this framework.

“We’ll be debating whether or not we’re safer under the clearing framework for a long time,” said the head of clearing at one major American dealer. “It’s hard to argue that there is not some reduction in systemic risk because clearinghouses require all market participants to collateralise their exposures. Just in that regard alone, the system has got to be safer and sounder.

“[That being said] whether or not steering all of the risk into clearinghouses is a good idea has been the debate and will continue to be open to debate.”

Regulators are unlikely to dismantle any of the major tenets of the clearing framework after such a long haul since the passage of Dodd-Frank in 2010. But they could turn their attention towards levying new sets of standards on the clearinghouses to further protect the market.

Momentum has grown over the past year for adding transparency into the major clearing firms’ operations to ensure that their risk mitigation services are robust and trustworthy. Participants are also asking for heightened standards regarding the suitability of products for clearing to ensure that clearing firms refrain from chasing profits by adding products that are unsuitable.

Some are asking for a change in perspective on clearinghouse failures, including a need for CCPs to pledge their own assets as backup in the case of a crisis.

“Clearinghouses are now too-big-to-fail entities and we are talking about recovery plans. But I think that’s the wrong conversation, we should be talking about resolution,” said Richard Prager, global head of fixed-income trading at BlackRock at a conference in September.

“We should be looking at the waterfall and the capital structure [too] … I think if those folks can provide returns from what is in some ways a government-awarded oligopoly, then they should have skin-in-the-game and have that capital first of all be more substantial and secondly be higher up in the waterfall.”

Unexpected praise

Given all the complaints regarding SEFs and the clearing structure, perhaps the most surprising development at this stage has been the admission by some market participants that the CFTC did a reasonable job in implementing Dodd-Frank, at least considering the circumstances.

“I think Dodd-Frank implementation has gone remarkably well. I think it’s a huge piece of legislation and the piece dealing with SEFs was extremely complex,” said Ron Levi, COO of GFI Group. “It’s far from perfect, but I think they’ve done a pretty good job of getting it out there and getting it working. It’s easy to criticise and there are certainly some issues remaining, but I don’t think I’m in that camp. I think I’m in the camp to say ‘well done’ to the CFTC.”

The praise may come as a nice bookend for outgoing CFTC chairman, Gary Gensler, who has been consistently vilified by the industry for taking an overly aggressive stance to regulations, while at the same time being criticised by those outside the industry for the slow pace of rule-writing.

Gensler, though, can rest easy knowing that he succeeded in ushering through two of the primary planks of OTC derivatives reform in the US before the conclusion of his four-and-a-half year term at the end of this year. Now the market will have its chance to coalesce around efficient best practices and new business strategies.

Overseeing that framework will be left to Timothy Massad, former assistant Treasury secretary and overseer of the Troubled Asset Relief Program, who, at the time of going to press, is slated to replace Gensler pending Senate confirmation.

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