OTC Markets Undergo Rapid Change

Terry Flanagan

OTC derivatives will be heavily affected asset classes by new regulations, according to Tim Dodd, head of product management at SunGard’s Capital Markets business.

“The end effects of the global drive in this area are only now beginning to be felt as the first rules on execution from the Dodd-Frank and Emir processes come into effect in the U.S. and Europe,” Dodd said in a blog posting. “As with any change, while there will be winners and losers, there are significant gains for first movers and certain infrastructure providers, and the broker-dealer community as a whole must expect its margins to come under further pressure.”

Swaps trading is a particular area of focus, especially since there are massive changes underway in the OTC derivatives markets which are predominantly regulation-driven, Dodd said. Given the relatively low transaction volumes, all swaps traders will not have the incentive for major technology-based innovation to lead change, but for all, innovation is required to continue to participate in these markets.

“The primary impacts of the drivers towards clearing and ‘organized’ trading appear clear: there will be a move from principal to agency trading, and collateral requirements for margin demands will be significant,” he said.

This shift from principal to agency trading is already on the rise, and swap market participants must adjust to working in a new exchange-based market structure, although with important differences that reflect the different liquidity.

“$600 trillion in outstanding OTC derivative notional value indicates a huge market, but estimated transaction rates are much less impressive,” said Dodd. “If we consider interest rate derivatives, which account for more than 75 percent of the OTC market, then average trade size of $200+ million and daily turnover of $2-3 trillion indicate only some 10,000 trades per day: a tiny number by listed market standards.”

Trade sizes in the cleared and electronically traded (and largest) part of the new market are likely to become much smaller, so that meaningful levels of liquidity should be achievable on many venues. Therefore, said Dodd, the role of broker-dealers will increasingly need to be an agency one, enabling connectivity and access to liquidity in a multi-channel landscape of trading venues: the SEFs and OTFs demanded by U.S. and EU regulations.

“Over the next two to three years, large tranches of global swap and fixed income trading will be transformed in broadly similar directions,” he said. “As with other increasingly electronic markets, they will resemble one another more closely, and will also look more like today’s listed markets.”

As a result of the Commodity Futures Trading Commission’s trade execution mandate, many swaps will, for the first time, trade on regulated platforms and benefit from market-wide, pre-trade transparency. In recent weeks, the “Made Available to Trade Determinations” filed by four swap execution facilities (“SEFs”) have been deemed certified, making mandatory the trading of a number of interest rate and credit default swaps on regulated platforms.

“The trade execution rules complement our other efforts to streamline participation in the markets by doing away with the need to negotiate bilateral credit arrangements and removing impediments to accessing liquidity,” said CFTC acting chairman Mark Wetjen in congressional testimony on Thursday. “In essence, the Commission’s implementation of the trade execution mandate supports a transparent, risk-reducing swap-market structure under CFTC oversight.”

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