End-user angst in Munich

Munich angstIn the years since the financial crisis, an important point about derivatives has often been overlooked: they serve a genuine need by helping real companies to hedge very real risks. This point came across loud and clear in a recent survey of end-users conducted by ISDA: 86% of respondents said over-the-counter (OTC) derivatives were either very important or important to their risk management strategies. This was also a recurring theme at ISDA’s annual general meeting (AGM) in Munich earlier this month, where a succession of end-users and academics stressed the economic benefits of derivatives and their value to the real economy.

These end-users generally feel the financial system is on a sounder footing today than before the financial crisis, largely as a result of regulatory changes. But enthusiasm for specific regulations varies significantly. For instance, trade execution rules got a thumbs down from investors, despite the fact these rules were meant to help those users, primarily by ensuring greater transparency. In that aim at least, regulators appear to have succeeded: 74% of respondents thought electronic trade execution would have a positive affect on transparency. But more than half felt it would have a negative impact on ease of use, while 39% and 36% thought it would have a detrimental affect on price and liquidity, respectively. That’s a higher proportion than those who thought the impact would be positive.

Another key area of end-user concern is a lack of regulatory harmonisation and the resulting fragmentation of markets. Nearly half of survey respondents thought the market was splintering along geographic lines – a finding backed up by other ISDA research. This point was also picked up by end-user speakers at the AGM, who talked of their efforts to minimise cross-border problems by reorganising their operations to ensure non-US entities avoid trading with US dealers. The result, they argued, was less liquidity and higher costs for certain products – something reflected in the end-user survey, which found 83% of those who had witnessed some level of fragmentation believe it had led to higher costs.

For the most part, though, many end-users – and corporates in particular – have been sheltered from the direct costs resulting from new regulation. Corporates are largely exempt from mandatory clearing requirements and from forthcoming uncleared margin rules, excusing them from having to stump up initial and variation margin on their hedges – money they believe would be better spent on investment and research and development.

But there are other indirect costs: dealers are subject to higher capital charges for uncollateralised trades via new credit valuation adjustment (CVA) rules. While European banks are exempt from having to apply this CVA charge for trades with corporate customers, other banks aren’t – and those capital charges are likely to be passed on. Dealers will also look to hedge any client transaction, and these offsetting trades will almost certainly require margin to be posted against them. The dealer would need to fund that margin, creating a cost that may well be handed down to the client.

End-user speakers at the AGM claimed not to have seen any marked increase in price so far, suggesting dealers are largely absorbing these costs at the moment. They did, however, say they had seen some banks pulling back from certain markets and products. In other panels, dealer representatives acknowledged banks now have to pick and choose, with higher capital and leverage costs forcing them to concentrate on those areas where they have an advantage or where they can meet return-on-equity hurdles.

That’s already having an impact, with liquidity diminishing significantly in certain markets, affecting the ability of end-users to manage their risks efficiently. One buy-side speaker said some customised products were either no longer available or were trading “by appointment” only. That’s a big problem, as tailor-made, bespoke contracts fulfil a real need by allowing firms to closely offset their risk. Any reduction in the availability or increase in costs for these products could encourage some companies to hedge less, some speakers warned – a result that would lead to increased earnings volatility, less certainty in cashflows and – ultimately – less investment, less job creation and lower economic growth. That fear was voiced forcefully by a number of AGM end-user speakers.

That scenario thankfully doesn’t appear to have played out yet. The end-user survey found that 79% of respondents plan to increase their use of OTC derivatives or keep their hedges at the same level during the second quarter of 2014. But higher costs, fragmented markets and less liquidity could eventually take its toll, depriving end-users of an important risk management tool.

That’s an unintended consequence no-one wants to see. Could we end up with less safe, less efficient markets? That’s the concern that was voiced over and over again in Munich.

Market fragmentation is becoming a reality


The global nature of the derivatives market has long enabled users to manage their risk efficiently. This is something ISDA has championed throughout its history, and it’s been our single biggest concern over the past few years. Thankfully, the Group of 20 (G-20) nations shared this concern when setting their roadmap for derivatives reform in September 2009.

Nonetheless, derivatives users have been warning for some months now that the rollout of the US swap execution facility (SEF) regime, and the extraterritorial reach of those rules, would lead to market fragmentation, with separate pools of liquidity emerging for US and non-US persons. Evidence is now emerging that this is indeed the case.

Research published by ISDA clearly shows that European dealers have been opting to trade euro-denominated interest rate swaps with other European counterparties since the start of the SEF regime on October 2, 2013. Based on the volume of trades cleared at LCH.Clearnet, approximately 90% of European interdealer activity in euro interest rate swaps is now being traded with other European firms, up from roughly 75% before October. That tallies with an earlier survey published by ISDA in December, which found 68% of respondents had reduced or ceased trading activity with US persons since the SEF rules came into effect, while 60% had noticed a fragmentation of liquidity.

So, why are these rules affecting the trading habits of European dealers? It can all be traced back to the last-minute inclusion of footnote 88 within the final SEF rules, agreed by the Commodity Futures Trading Commission (CFTC) last May. That footnote essentially required all multiple-to-multiple trading platforms to register as SEFs, even if the products they offer aren’t subject to a trade execution mandate – an inclusion that sent a number of venues scrambling to submit their applications before the October 2 deadline. Combined with that was uncertainty about final interpretive guidance on the cross-border application of Dodd-Frank, published in the Federal Register on July 26. While the treatment of SEFs wasn’t explicitly covered, a number of non-US electronic trading platforms interpreted the guidance to mean they would need to register with the CFTC if any US person – including foreign branches of US banks – traded directly or indirectly on their venue.

Given the complex registration process, and the need for SEF customers to sign lengthy end-user agreements, a number of non-US platforms decided it was simply easier to ask US participants to stop trading on their platforms, or to split their businesses between US and non-US liquidity pools. The latest ISDA research shows this has become a reality.

Less clear is how this has affected over-the-counter derivatives markets. A fragmentation of liquidity could lead to less efficient pricing in certain markets, as well as greater volatility – something the G-20 stated it wanted to avoid in September 2009. According to the December ISDA survey, 46% of respondents said the fragmentation had led to different prices for similar types of transactions, but this trend may become more pronounced over the next month. While trading platforms have had to register as SEFs since October, US derivatives users haven’t been obliged to use them – they could continue to trade by phone or via single-dealer platforms. That will change on February 15, when the first trade execution mandates come into force. From that point, US participants will be required to trade those interest rate derivatives subject to made-available-to-trade determinations on registered SEFs or designated contract markets. Non-US entities won’t – and will probably continue not to want to.

Global regulators have talked a lot about the need for cooperation to ensure a consistent application of the new regulatory framework, and to avoid fragmentation and less efficient markets. This latest evidence suggests fragmentation is happening, and that can’t be a good thing.