Last week, ISDA published a new Discussion Paper – Costs and Benefits of Mandatory Electronic Execution Requirements – which examined the implications of these mandates in the Dodd-Frank Act as interpreted by the CFTC. We believe the paper made a compelling case that these requirements would not pass a cost-benefit test, but we also stated that we look forward to the test the CFTC will no doubt produce. In this week’s derivatiViews, we’ll focus on one of the key issues in the study – the benefits to small users. After all, small users have been regularly cited as the real beneficiaries of the electronic execution mandates.
Let’s first agree on some assumptions. Small users have to be financial entities – banks, insurance companies and investment firms. Financial entities are covered by the mandatory clearing requirement as well as the electronic trading requirement. In fact, if they hadn’t been forced to clear, they wouldn’t be subject to the electronic trading requirement.
Let’s also assume a typical interest rate swap for this group is $10 million. That might seem like a large amount to some of our readers but if the average size trade is much smaller, it will be hard to see how potential benefits can amount to any worthwhile sum. Let’s also agree not to debate the issue of clearing and current pricing for interest rate swaps. Presumably, if swaps have not been collateralized in the past, dealers charged these small users for credit costs. These credit costs may, or may not, have exceeded the costs of clearing. Let’s assume that the average swap is for five years as well.
Now let’s turn to an important finding in the study. The study took pricing runs from three dealer electronic platforms. The runs were synchronized so that we receive pricing at precisely the same time – once a minute each trading day for four weeks (at a time, July 19 through August 12, when volatility had begun to spike). These platforms were designed largely for plain vanilla swaps with small users who had been pre-approved for credit. What the study showed was that the bid-offer spreads on these platforms were one-half basis point per annum or lower in most maturities with a greater than 90% confidence level. A zero bid-offer spread (which is the smallest spread possible and which is obviously impossible to achieve in practice) represents a quarter basis point improvement from a half basis point bid-offer as both sides of the market get better pricing. A quarter basis point improvement over five years has a net present value of about 1.2 basis points or 0.00012 in price terms. For a $10 million swap, that amounts to $1,200. Depending on interest rates, it might be more or less, and in our study we rounded it down to $1,000. For a $5 million swap, the improvement will be half of the amount for a $10 million swap, or $500 to $600.
It is our contention that this pricing will be available to clearing clients through dealer platforms for small plain vanilla swaps. Once a client is approved for clearing, there is absolutely no reason why these facilities will not be available to the small user. Indeed, that is the reason why the platforms were developed – to provide automatic execution for small trades. A clearing client just has to demand access to the platforms before agreeing to become a clearing client.
So the greatest possible savings is $600 or $1,200 per trade. That excludes execution costs. All the development costs of SEFs, dealers, SROs and the CFTC have to be passed along. This will likely increase costs for users. Perhaps the entry of new dealers to the market will bring down spreads? To what? Consider that the study did find that the trading costs for futures execution of swap-like strips of Eurodollar contracts was actually greater than the trading costs for interest rate swaps.
All of this gives us a funny feeling about why we haven’t seen a cost-benefit analysis from the CFTC. Particularly since it is required by law. And as we all know, when Congress passes a law, we have to follow it.