Thursday, July 23rd, 2015
by GEORGE BOLLENBACHER
Much has been written about the impact of regulation on the fixed income and derivatives markets, but market forces also are transforming the space. How are the fixed income and derivatives markets evolving, what is driving the changes, and how can the buy side cope?
Ever since the passage of the Dodd-Frank Act and EMIR, and with the looming implementation of MiFIR/MiFID, there has been a lot of press coverage of the impact various regulations have had on the performance and adequacy of markets, particularly the fixed income and derivatives markets. To mention a few recent items: an op-ed by Michael S. Piwowar and J. Christopher Giancarlo, of the SEC and CFTC, respectively, entitled “Banking Regulators Heighten Financial Market Risk”; an opinion piece by BlackRock, entitled “Addressing Market Liquidity”; and a joint regulatory report on the Treasury market spike of Oct. 15, 2014. With all these voices, and others, raised about the state of the markets, perhaps we need to take a clear, and hopefully unbiased, look at how the fixed income and derivatives markets are evolving, what the causes are, and how the buy side, in particular, can cope.
In order to get the picture, let’s separate the influences into regulatory and market, the latter referring to the market for services as opposed to the financial markets.
Regulatory Influences
The first thing we need to look at is specific regulatory changes and their impacts, starting with the lowest impacts and working our way up.
Reporting – Here, aside from the obvious discontinuity between the US and Europe, the bulk of the effort will be borne by the dealers. European buy-siders do need to make sure someone is reporting for them, and, since they remain responsible for the reporting quality, that the reports are accurate. The accuracy requirement may be the bigger of the two, since the quality of reporting has been very bad worldwide, and the EU regulators are making noises about cracking down on bad reporting. European buy-siders who delegate their reporting to their trading counterparties may need to winnow down their trading stable to those firms that can be trusted to report for them properly.
Trading Venues – In this area we face acronym overload, with SEFs, DCMs, MTFs, OTFs, and SIs. The US has had the first experience with mandatory exchange trading of OTC derivatives (is that term now an oxymoron?), so it’s worth looking at the US experience. The first thing we see is that exchange trading is anything but mandatory, even where it’s mandatory. SEF trading as a percentage of overall MAT trading is about 50%, largely because it is laughably easy to trade non-MAT versions of MAT swaps, as well as using the exclusions for block and end-user trades. The second observation of note is the bifurcation of the SEF markets into dealer-to-customer (D2C) and dealer-to-dealer (D2D) specialties, in much the same way the old OTC market worked. Plus ca change? In all, the much-heralded era of exchange trading of swaps is a long way from reality.
Clearing – In many ways, this regulatory change has the biggest direct impact on the buy side. One major result is the concentration of risk. Where a large buy-sider could spread its risk across many counterparties, it now must accept one or two CCPs as counterparties. Everyone, at this point, is aware of the worldwide concerns with the potential failure of a CCP. There is, however, a second, perhaps more unsettling, impact of required clearing: opacity. Most buy-siders interact with a CCP through a FCM, which means that CCPs have no idea who their ultimate credit risk is. Since both CCPs and FCMs are in a competitive business, and since one way to compete is on risk, the ultimate impact of mandatory clearing on the market may be that everyone is carrying a loaded pistol in a dark room.
Capital and Liquidity – Finally, the capital and liquidity requirements being implemented under Basel III have rewritten the rules for almost every aspect of the capital markets. The rapid comprehension within banks of the meaning of “denominator creep” has already prompted them to scale back many of their capital markets services, from trading to clearing. Although much of the public’s attention has been focused on Dodd-Frank, the deepest and longest-lasting regulatory impact will probably be from Basel III.
Market Forces
While the regulatory forces above have been gestating, another set of influences has been at work – changes in the markets themselves. Let’s look at those now.
Costs and Spreads – Long before the great recession and any resulting legislation, the natural forces of increased competition and efficiency were at work. These two inevitable trends are universal, impacting every market, even those as disparate as energy and mobile technology. In the capital markets, the trends are evidenced by the use of technology across every part of the trading cycle, and by the pricing pressures that competition brings. In other words, automated trading, narrow spreads, fragmented markets, and some reductions in the liquidity of non-standard products.
Low Volatility and Trading Volume – This phenomenon is not a natural force, but a result of the seemingly unending quantitative easing of the various central banks as a result of the great recession. As these central banks inject money through the mechanism of purchasing bonds, they artificially drain the markets of tradable securities and keep price volatility artificially low. This artificial situation may have masked a serious problem, namely …
Attrition of Market-Making – Both of the previous forces have the entirely predictable impact of reducing the incentives to make markets, so it shouldn’t surprise us that the bond and derivatives markets are moving inexorably away from a principal to an agency structure. This is not a complete change, of course, and increased volatilities and volumes may return principal trading to its former levels; but that process won’t be simple or painless. Buy-siders will have to go through some unpleasant market experiences before the trading banks come back in force, if they ever do.
Evolution at Work
So where are all these forces taking us, especially from the buy-side view?
Total Cost of Ownership – Everyone is becoming aware that trading decisions are being heavily influenced by a series of things that happen after the trade is done. If I have to clear this trade, which is the most efficient CCP? Will the choice of CCP affect my price? Whom can I trust to report for me? When I want to get out of this position, will there be enough market liquidity to accommodate me? Which clearing agent will be the best choice over the long run?
Embracing the Agency Model – Years ago the equity markets were entirely agency, and the fixed income markets were entirely principal. Now the world, while not exactly turned on its head, looks decidedly different. Fixed income buy-siders are having to understand how a bond or swap trade gets done on an agency basis, whether one must become a member of a venue or use a broker in order to trade, and who bears the cost of a trade that can’t be cleared. As clearing agents fall by the wayside, trading agents rise out of the mist.
Manufacturing Liquidity – As Basel III forces banks to re-examine their market-making commitment, other firms, such as the principal trading firms (PTFs) identified in the joint regulatory report, have stepped to the fore. In fact, the report indicates that, during the Oct. 15, 2014, Treasury spike, the PTFs stayed in the market while the primary dealers stepped back, if only momentarily. We will probably see liquidity come from other sources than the dealer banks, including possibly unguaranteed affiliates, as we have been seeing in the swaps market. To be sure, manufacturing anything has its costs, and we should expect to see the costs of trading rise somewhat as the need for liquidity intensifies.
Closing Out Positions – In the swaps market particularly, the cost of maintaining back-to-back positions has been recognized as prohibitive. Dealers have already begun their efforts to close out positions as soon as they lay them off, and we should expect this practice to accelerate. This will have two main impacts:
- Because standardized contracts are much easier to compress, we should see a pronounced price advantage to buy-siders for using them. For those who have non-standard hedging needs, this will introduce basis risk; but that is something that the futures market has dealt with for decades, so the buy side should be able to manage it.
- As dealers exit swaps positions ASAP after executing the customer’s order, this will leave CCPs with a portfolio of positions with only the buy side and non-traditional players. Whether anybody in that business knows how to deal with that kind of swaps market, which, after all, has been the futures model for years, remains to be seen.
Evolution has always been a messy business, of course. Some species become extinct, others unexpectedly rise to dominance, and the whole process has been called survival of the fittest. I guess there’s no reason why the financial markets should be any different.
