This will be the year that the much-awaited over-the-counter derivatives rules will be finalized, according to Will Rhode, Tabb Group’s swaps expert and its director of fixed-income research for the advisory and research firm.
But how will the much-awaited reforms, the result of the Dodd-Frank Wall Street Reform Act and Consumer Protection Act of 2010, play out? Will OTC swaps, now most of which are using clearing and largely shunning the once popular bilateral model, be safer and more competitive, as envisioned by those who pushed reforms through Congress?
Sometimes reforms don’t work out the way regulators and lawmakers envision.
And Rhode had some interesting and surprising answers in a recent question-and-answer session with CQ&D. He’s not sure there will be more competition, because most of these contracts will be more transparent and cleared instead of privately processed. The biggest dealers will remain strong in the OTC derivatives business, he predicts. Rhode also thinks that, after all these reforms go into effect, the OTC market will contract, although he isn’t sure by how much. He also thinks that reforms of OTC derivatives might have an unintended consequence: Owing to the incredible costs of clearing these controversial contracts, Dodd-Frank might make the futures business more popular.
CQ&D: What has been settled and what needs to be settled on the swaps rules for clearing these contracts?
Will Rhode: We have a timeline for clearing for each market participant. You can count on the most standardized rates and credit products to be first out of the gate.
CQ&D: Which will be when?
Will Rhode: In March, swaps dealers and active funds have to start clearing; in June, it will be asset managers; and in September, ERISA and pension plans will have to start.
CQ&D: The first ones to be cleared will be…
Will Rhode: Standardized interest rate swaps and index CDSs.
CQ&D: So the relatively easy ones go first, right?
Will Rhode: Yes.
CQ&D: Institutional firms have been lining up to obtain more swaps clearing business. Doesn’t that mean there will be more competition to trade, process and settle these contracts? But you’re not sure that will actually happen. Why?
Will Rhode: Well, I think the clearing space is actually going to be a prohibitively difficult space, from an intermediary perspective.
CQ&D: How?
Will Rhode: You need capital to clear swaps, and capital is becoming more expensive. Swap-clearing brokers will need scale to compete. There is the potential for FCMs to start to participate, but I think it is not as easy to clear swaps as it is to clear futures.
CQ&D: Why?
Will Rhode: You need make various technology investments and capital provisioning in order to be able to participate in swaps clearing, and that can be a heavy lift. It is pretty difficult to demonstrate your value proposition when the largest dealers are competing on price. At the moment, winning clearing business from the buyside is very much the order of the hour.
CQ&D: You’ve said that the OTC landscape might not change very much after the reforms are completed based on the idea that only the largest firms will be able to compete effectively under the new rules. Why is that? Is it because new rules will require enormous amounts of collateral?
Will Rhode: The main reason it is going to be more expensive is because there is a pretty substantial capital commitment taken on by the clearing intermediary.
CQ&D: How?
Will Rhode: When they provide the buyside firms with access to clearing organizations, they have to contribute to the default fund. There is also the handling of initial margins across a variety of collateral types between the investor and the clearing organization. Then there is the process of cross-product margining efficiencies, and that requires a technology investment in order to take a portfolio-wide view of a client’s positions and discover potential netting efficiencies.
CQ&D: Under the new model, the clearinghouse and the intermediary, the dealers offering these products, will have different roles in the clearing and processing of OTC trades?
Will Rhode: The intermediary will have a wider view of the client’s portfolio. They would not only, for example, see that they have a certain swaps clearing at, say LCH; they would also see the positions of OTC swaps, as well as futures positions at the CME. Essentially, for them (intermediaries) to be able to net out and show some of their clients how they can improve their collateral costs, that would require a really significant systems upgrade.
CQ&D: That means some of the dealers, or intermediaries, who offered these contracts before Dodd-Frank, are going to have to do better?
Will Rhode: Most of these systems that are being employed are legacy systems from the prime broker community.
CQ&D: And so…
Will Rhode: A lot of FCMs just don’t have that kind of technology.
CQ&D: How much to get up to snuff?
Will Rhode: I would say it is going to be in the tens of millions of dollars for individual firms, around $385 million from an industry perspective.
CQ&D: So to be an effective player in this new environment, you have to be?
Will Rhode: The two pressure points to be in this service are the technology investment and then, of course, there are the big capital costs that we have been discussing.
CQ&D: And facing all these costs, many firms-hoping to cash in on this supposed bonanza in clearing OTC swaps contracts-maybe are going to think twice?
Will Rhode: When any intermediary is considering the business opportunity, they’re thinking, “I have to spend a bunch on tech and it will cost a bunch on capital, so how exactly am I going to make money in this business?”
CQ&D: Only the biggest firms, the ones who previously were the biggest in OTC contracts, generally can live up to that?
Will Rhode: Yes, so that is why we’re seeing a lot of firms that can demonstrate scale are actually the ones that are better placed to profit out of the new clearing requirements. In this transformation period we actually see a concentration effect, narrowing the world of swaps trading from 14 dealers down to five.
CQ&D: One of the principles of Dodd-Frank is to promote more competition because many believed the problems on 2007-2008 were the result of not enough competition, of a few firms having too much power over the market. Now, as these OTC derivatives go into place, please tell me who will be the winners and the losers?
Will Rhode: I think from a clearing perspective, the winners will be the big dealers.
CQ&D: So nothing changes?
Will Rhode: Not enough, not much, because as I have said, I think it becomes more difficult for individual FCMs to profit from this opportunity. That is not to say that space won’t eventually evolve. But in this transformation period, especially around the confusion around what is the technical implications, we’re seeing firms hesitate before committing to the business.
CQ&D: Which means?
Will Rhode: What are the regulations and how is one business positioning their service offering around another, and who is charging for capital and who is not, who is charging how much for clearing and how did they come to that amount. You know there’s a lot of confusion in the marketplace, and the big dealers are very much focused on the big funds, and they’re looking to compete for those 200 big names, and they’re competing to see how those guys get over the clearing hurdle.
CQ&D: Besides the big boys, what happens to the rest of the OTC derivatives market?
Will Rhode: We’ve already seen that the second-tier firms might not see the business logic at the moment, and we also know some of the smaller funds won’t get serviced by the big dealers.
CQ&D: Why?
Will Rhode: There won’t be the bandwidth to bring them on board as the clearing requirement goes live. They may not want the business from smaller funds either.
CQ&D: What happens to the size of the market as many funds can’t be serviced and to the goal of more competition?
Will Rhode: The question becomes: Do we see concentration among the big dealers and the big buyside firms-the ones that actually will deal with the clearing requirement? The rest could just stop using swaps. They may convert to futures, for example.
CQ&D: But, ultimately, will the reforms open up more competition?
Will Rhode: I think it opens up competition from an execution perspective. We will see more agency-type execution models.
CQ&D: Is the agency-only model now the preferred OTC derivatives model in this new environment?
Will Rhode: The jury is still out on how the agency business model survives in the post-Dodd Frank swaps environment. But the rational thinking has been that clearing is a value-added service that can be charged and that the margins on execution will become so wafer-thin as it becomes a commoditized business.
CQ&D: So a clearing model is still being determined in the marketplace…
Will Rhode: Yes, but we know that a lot of the biggest investment banks have reorganized their trading floor architecture to allow clearing and execution services to sit on the same floor, covering not just swaps, but also listed futures. They are looking to be basically flexible, depending on the way the market evolves.
CQ&D: And so?
Will Rhode: Wherever they see the alpha, they’ll charge for that and they’ll give away the other stuff that is commoditized and not of much value.
CQ&D: We’ve been talking about the biggest dealers. How about the clearinghouses? Will they be big winners?
Will Rhode: It comes down to what kind of portfolio and margining efficiencies they can demonstrate and whether they can show a high degree of open interest in their relevant instruments. The obvious observation is that LCH’s SwapClear is the dominant player in interest rates clearing for dealer-to-dealer, and they have also seen a high degree of uptick in dealer-to-client clearing.
At the same, they are experiencing a high degree of competition from the CME, who are not only demonstrating their ability to client clear swaps, but who also have another feather in their cap with regard to alternative products, such as swap futures. They will essentially compete with the swap product and could erode interest in swaps as an asset class.
If everything is predicated off the amount of open interest you demonstrate, it really comes down which product each house clears best. IntercontinentalExchange is strong in credit and commodities and also plans to list CDS index futures later in the year. I think the potential acquisition of NYSE will give them a good footprint in cash.
CQ&D: The OTC derivatives clearing rules, you believe, will substantially be finished this year?
Will Rhode: The SEF rules should be ready in February. We already have dealer registration place and trading reporting is live as of January 1. By the end of 2013, we will have been done from a derivatives regulation point of view in the U.S. That’s not to say there would be some elements outstanding. There is initial margining treatment. There is the Volcker rule to be negotiated.
CQ&D: How will they determine if something can be exempted from the clearing mandate?
Will Rhode: If a clearinghouse can’t clear it, then it will simply have to be done bilaterally. And then it has to be subject to a separate set of margin requirements as determined by the central banking authorities.
CQ&D: Is it your contention that the market for OTC derivatives will contract?
Will Rhode: Yes.
CQ&D: How much and why?
Will Rhode: How much is a good question. But the reason why is, the cost of trading these instruments is becoming prohibitively expensive. And also because of the migration away from standardized, commoditized business into an exchange-traded futures environment.
CQ&D: For some institutional clients, it won’t be worth it.
Will Rhode: You will see those firms that don’t have to use a swap, which previously was free, who will choose to use something else. There’s a whole bunch of the investment community that doesn’t have to use a swap that could trade as a future. There’s a whole variety of hedge funds and asset managers that would be in that position.
