Boom Times?

Industry Pro Sees Opportunity In OTC Swaps

Boom times are ahead for swaps contracts because more of them are going to be cleared, which will make people feel more comfortable about them. That’s what swaps players are hoping, as the need for these contracts grows. And that’s what Goldman Sachs is betting, having set up an agency-only clearing group some two years ago, as Dodd-Frank was passed. 

Dodd-Frank is changing the business because it is pushing most swaps business out of the bilateral, dealer-to-dealer model, and into a more transparent clearinghouse model.

These are the expectations of Michael Dawley, a 30-year clearing veteran and global head of futures and derivatives clearing at Goldman Sachs. His team is an agency-only group that is very different from Goldman’s clearing and execution services. Dawley recently sat down with CQ&D to discuss how the regulators are writing hundreds of new rules to govern swaps, rules changes that could take some time.

He also discussed why the dramatic changes in the business will benefit his firm and others that meet the goals set by Dodd-Frank: Swaps that are more transparent and that have stiffer collateral requirements presumably will ensure that, when the worst happens, markets will not collapse.

 

CQ&D: How would you describe your responsibilities as co-head of the futures and derivatives clearing services business at Goldman Sachs?

Mr. Dawley: I oversee the futures and client cleared swap business, which includes OTC client clearing. We service a broad array of institutional clients. These include asset managers, sovereigns, corporates, pension funds, endowments and some larger hedge funds.

 

CQ&D: What differentiates your business from others at the firm?

Mr. Dawley: We are just one of many client-facing businesses at Goldman Sachs. We operate under an agency business model and as a service provider to our clients. For regulatory and client confidentiality reasons, we are walled off from the trading franchise. We have historically serviced futures clients and are the largest FCM by total segregated balances. We have also built a new post-Dodd-Frank cleared swaps business, which was modeled after our best-in-class futures business and leverages much of what we have built over the last 30 years.

 

CQ&D: What products and services do your clients want?

Mr. Dawley: Clients want access to a broad array of markets. That means the ability to execute and clear on some 70-plus markets across the world. Our clearing service provides a host of value-added features, including consolidated reporting, average pricing, single currency margining, position limit monitoring tools, "what if" margin calculators, reconciliation tools, data files and various other portal offerings. For execution, we also offer a suite of products including our own REDIPlus trading application, along with other popular vendor execution products. We also have execution professionals positioned globally, covering clients.

 

CQ&D: What products and services do clients clearing swaps want?

Mr. Dawley: Clients clearing swaps will want many of the same services and tools we offer in futures. Additional products offered are collateral upgrades for initial margin, additional "what if" margin calculators and margin optimization tools.

 

CQ&D: How do cleared swaps differ from bilateral swaps from a risk management point of view?

Mr. Dawley: From a market risk perspective, a bilateral swap and a cleared swap offer the same risks and same returns. The main differences come in counterparty risk management and in managing funding and capital. From a counterparty perspective, once a swap is cleared, the client no longer has counterparty exposure to their executing broker, since they face the clearing firm and clearinghouse. This is a core risk management benefit of cleared swaps. From a funding and capital perspective, margin terms for cleared swaps are potentially very different from bilateral swaps, which may modify execution prices and real returns, and will require careful capital and funding management practices for larger portfolios.

 

CQ&D: Isn’t it possible that a clearinghouse could also default?

Mr. Dawley: Yes. And we prepare for that, too. We want full transparency into clearinghouses’ risk waterfalls and to know exactly what happens at the end of that waterfall. While the possibility of a default at a properly designed and structured clearinghouse is remote, clarity around what happens in such a case needs to be understood by clearing members, clients and regulators.

 

CQ&D: If a clearinghouse did default, what safeguards need to be in place?

Mr. Dawley: Safeguards are in place to try and prevent a clearinghouse default, but if it were to occur, those holding positions would likely prefer to have their positions continue to exist in some form versus a complete liquidation. Novating to another clearinghouse or reverting back to bilateral might accomplish that.

 

CQ&D: And that could have a systematic effect?

Mr. Dawley: It is hard to answer that question without having a real situation to evaluate. Depending on what caused the clearinghouse default, there certainly could be systemic challenges to deal with. A client of a clearing member causing that same clearing member to default could ultimately lead to a clearinghouse default, after all guarantee fund contributions and any other assets in the waterfall are consumed. Which client or clearing member defaulted and why would need to be known to determine the severity of the systemic situation.

 

CQ&D: And meanwhile, even after the Dodd-Frank rules are finished, the bilateral model will continue to be used in some instances because there are some swaps that could never be cleared, right?

Mr. Dawley: Bilateral trades have worked for years, and people have learned how to manage their counterparty risk. The buyside has gotten comfortable with their dealer counterparts and vice versa. Dealers have gotten comfortable with each other. For those swaps that are not clearable, we expect they will be managed the same way, albeit with potential additional margin and capital requirements.

 

CQ&D: And the rules that govern this kind of business will be very important to your clients, right?

Mr. Dawley: The rules that govern uncleared swaps are starting to take shape. It will be important for us and our clients to understand costs, margin and capital requirements, and anything else that will impact these products.

 

CQ&D: The goal of regulation is to ensure that everyone is made whole if a firm fails. But isn’t there also a possibility that, if margin requirements are set too high, institutional clients will find it too expensive to use the OTC swaps they need?

Mr. Dawley: I disagree with that. I feel the goal of regulation is to ensure that markets and market participants operate in an orderly manner. But you are right. It is important to identify the right balance between proper risk management and the cost-effectiveness of the product. The combination of margin requirements, guarantee fund deposits, operational costs and other factors will dictate the demand for the product.

 

CQ&D: How long do you think it will be before these Dodd-Frank rules are finally hammered out by regulators?

Mr. Dawley: The CFTC’s goal is to get them done by the end of the year. The most critical thing to get right is the sequencing of events and implementation process. This will and should take longer so stakeholders including the buyside, sellside and clearinghouses can absorb and comply with all the new rules. Going fully live before everyone is ready is risky and could lead to unintended consequences.

 

CQ&D: Is there an order in which it will get done?

Mr. Dawley: Once again, sequencing is important. Clearinghouses need to determine which products they are capable of clearing. FCMs need to scale up their ability to clear these products. All constituents need to ensure that proper risk management is in place. In addition, a whole host of additional rulemakings need to be finalized and implemented over a time frame that makes sense for the industry as a whole.

 

CQ&D: Unlike equities, which have had falling volume, you’re gearing up for an expected rise in volume in the next few years.

Mr. Dawley: In futures and derivatives clearing services, our volumes are actually up year over year. And if you incorporate all the swap activity that’s expected to clear over the next year or so, I believe the volume is going to increase. The OTC marketplace is huge. And moving a large percentage of the eligible products over to a cleared environment is going to involve a lot of new volume.

 

CQ&D: The perception will be, after all the rules are put in place, that popular swaps products are safer than three years ago?

Mr. Dawley: Exactly. Some of that is perception, but much of it could become reality. We want to assure that all of the new requirements will work, add value and enhance risk mitigation.

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