Market fragmentation is becoming a reality

fragmentation

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.

Should I stay or should I go?

Everyone knows that two of the busiest days around the office are the day before you leave on vacation and the day you return. For some of us at ISDA today is getaway day, but that doesn’t mean there isn’t time to spare a few thoughts on the current state of the derivatives markets.

We had something of a “July Surprise” with the announcement on July 11 that peace was at hand between the CFTC and European regulators on cross-border derivatives regulation. We viewed that announcement, as many people did, as a positive development and a serious attempt to advance the discussion of global regulation of a global business.

As is often the case with broad pronouncements, however, the detail is in the detail, to coin a phrase. The next day the CFTC provided its final guidance on cross-border issues and additional time for compliance under an exemptive order. It is clear from the detail that the process of determining substituted compliance is going to be a critical one. It will be important to get both the substance and the process right. You will be hearing more from ISDA on this in the days ahead.

The CFTC work plan for derivatives is largely complete, with the finalization of the cross-border guidance and the publication earlier in the summer of SEF rules and related rulemaking. We will continue to work through the implementation challenges our members face, including the third wave of mandatory clearing in early September, but the drumbeat of deadlines is fading on the US front.

But don’t think it will be a vacation from here on out — far from it. Still, at least there will be a change in locale — Europe in particular, but all over the globe as well.

Europe is considering its approach to mandatory clearing and our various product steering committees are reviewing ESMA’s discussion paper. Confirmations and portfolio reconciliation face mid-September deadlines. And the European approach to the G20 commitment on execution will be hashed out over the course of the Fall through the consideration of the Markets in Financial Instruments Regulation in the trilogue process. We will be actively engaging with policy makers to identify areas with particular market sensitivity.

Globally, we are expecting approval by the G20 of the proposals on margin for uncleared derivatives. We have written extensively, both in derivatiViews and in submissions to regulators, about our significant concerns with the proposed initial margin requirements. It seems clear that initial margin in some form and quantum will be required, so we are also working on the development of a standard initial margin model to facilitate the introduction of any initial margin that might be required. Whatever the G20 decides will need to be implemented at national levels, so this issue is going to be on the front burner for months to come.

There are other things that await your return from vacation — major regulatory capital proposals, consideration of benchmarks, new credit derivative definitions, to name a few. In a few weeks, as summer ends (or winter for those of you in the southern hemisphere), and you feel the need to quickly get up to speed on all the developments affecting derivatives, consider attending our annual regional conferences in New York or London in September or in Asia in October. Details are on our website.

Wherever you may be headed—or even if you are staying put—safe travels and we look forward to your continued involvement and support.

Why Limit Customer Choice on SEFs?

Last week we published the results of a survey of buy-side firms on proposals to mandate how many quotes must be requested when utilizing a swap execution facility (SEF). The CFTC proposal would require a minimum of five quotes and the entire industry has been waiting to see what the final rules will say on this point.

The survey, which we conducted with the Asset Manager Group of SIFMA with additional input from the Managed Funds Association, indicates overwhelmingly that the five quote minimum requirement will mean higher transaction costs, wider spreads, constrained liquidity, exposing of investment strategies, migration to different markets and use of alternative products that are not traded on SEFs.

Is this what regulatory reform was intended to achieve?

The fact is, the creation of SEFs was intended to provide a third way of trading derivatives, fitting along a spectrum that included the traditional means of OTC derivative trade execution on the one hand and the exchange traded world on the other. Sitting in the middle of that spectrum would allow SEFs to blend the best of both worlds. If SEFs are not sufficiently different from the former or too much like the latter, we would fall short of one of the goals of the G20 and the Dodd-Frank Act.

Dictating, and in the process limiting, customer choice does not seem to us to be a good way to achieve those goals. A minimum quote requirement takes the decision out of the hands of the users of the products with no clear demonstration that better pricing, lower costs or greater liquidity would result.

And who is more able to opine on such matters than the participating firms in the survey? Asset managers, hedge funds, insurance companies, pensions, foundations, endowments, corporates and others, together holding nearly $18 trillion in assets responded to the survey. Does someone other than those institutions know better than they what suits the needs of their accounts and investors?

SEFs can and should flourish, if we get the regulatory structure right. Many firms are eagerly awaiting the final rules from the CFTC so that they can begin final preparations to register as SEFs and launch their offerings. Rigid requirements with no demonstration of benefits, such as minimum quote requirements, will only weigh down these innovative offerings.

Let’s not burden SEFs and their many potential customers before they even get up and running.