Fragmentation Worries OTC Users: Survey

Terry Flanagan

Fragmentation in the OTC markets is being driven by a lack of cohesion by national regulators on execution, reporting, and clearing of swaps transactions, according to a survey by the International Swaps and Derivatives Association.

“We don’t want market fragmentation,” ISDA CEO Scott O’Malia said at a press briefing on Tuesday at the ISDA North America conference in New York. “In the end-user documentation, we have concerns regarding fragmentation, and the cost, and the quality of the liquidity. That’s a concern for end users, and they believe it’s going to undermine their ability to get access and get good pricing.”

Although an overwhelming majority of end users intend to keep their use of derivatives at similar or higher to current levels over the last three months of the years, the survey shows that they are concerned about the impact of a lack of regulatory coordination, market fragmentation and increased costs of hedging.

More than half (54%) of end users agree that market fragmentation is occurring along geographic lines a s a result of new regulatory requirements, with most believing it is increasing the costs of OTC derivatives. More than half of survey respondents prefer to trade with dealers from their own jurisdictions.

Evidence has emerged that over-the-counter derivatives markets have fragmented along geographical lines since the start of the swap execution facility (SEF) regime in the U.S. on October 2, 2013. That trend has been especially notable for euro interest rate swaps, with European dealers opting to trade with other European parties, according to a July 2014 ISDA research note.

This development has accelerated since the start of mandatory SEF trading in the U.S. from February 2014, and the market for euro interest rate swaps is now clearly split between US and non-US counterparties.

Following the implementation of the SEF rules on October 2, 2013, the percentage of European-to-European interdealer volume increased from an average of 75% to an average of 90% by January 2014. This trend accelerated further following the first MAT (Made Available to Trade) determinations coming into force on February 15, 2014, with the average reaching 93% between February 2014 and May 2014. In the U.S., interdealer activity has dropped off sharply over the past 12 months.

“Some of the fascinating things out of the data are that 93% of the European market is dealer-to-dealer, and the U.S. participation has dropped off pretty significantly, from roughly 25% to 7%,” said O’Malia.

According to the survey, 65% of respondents believe that derivatives are important for managing exposures so their firms can improve pricing, operating expenses and returns. “It is clear that end users around the globe see OTC derivatives as vital risk management tools and expect to continue using them to hedge their risk,” O’Malia said.

ISDA has been lobbying regulators to extend a December 2015 deadline for margin requirements for uncleared swaps. “That’s presenting a lot of challenges to the industry, particularly on the buy side with regard to people having to post margin or who haven’t done it before,” said ISDA chairman Stephen O’Connor. “Our official position is that the December 2015 deadline is too tight and there needs to be a more measured implementation to avoid disruptive events in markets.”

The Working Group on Margin Requirements (WGMR), an industry group, has developed a methodology for initial margin which could be used by market participants. A common methodology would have several benefits to the market, such as permitting timely and transparent dispute resolution and allowing consistent regulatory governance and oversight. In order to realize these benefits, agreement between market participants and global regulators on several key assumptions will be required.

“WGMR effectively has done its job and has now handed over to local regulators and to the industry to put those recommendations into practice,” said O’Connor.

Featured image via wacomka/Dollar Photo Club

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