US Buy-Side Swaps Trading 2012: I Can See Clearing Now Executive Summary The swaps market is on final notice. Now that the Commodity Futures Trading Commission (CFTC) has published its final definitions of a swap dealer (SD) and major swap participant (MSP) in the Federal Register, participants have only until the end of July to apply. Rules for clearing and for swap execution facilities are still

Is the Buy-side ready? Not by a long stretch. It is no closer to discovering the alchemy that will conjure an estimated $1.6 trillion out of thin air so that margin can be deposited with central clearing counterparties (CCP). And even though new entrants are clamouring at the door, the benign influence they promise in terms of tighter bid/offer spreads, better liquidity and enhanced competition feel a long way away. That is because the stumbling block that is over-the-counter (OTC) derivatives market reform looms so large. It is hard to see what might exist on the other side.

But folks are starting to play out hypothetical scenarios. Among them: where will I clear? How much will it cost? Have I done a test trade? How will I source liquidity? What alternative products could I use? How will I manage basis risk? How will I access a Swap Execution Facility (SEF)? Could a Central Limit Order Book (CLOB) work? Should I execute with my Futures Commission Merchant (FCM)? Is that even allowed?

Meanwhile, dealers sense an opportunity to seize market share in a new trading paradigm, akin to the prime broker land grab of the eighties. But their fees have exploded as risk capital requirements manifest themselves on bank balance sheets. The buy-side is overwhelmed by the fees dealers are charging for client clearing. Tension accompanies this period of transformation. They want the sell-side to guide them through a confusing period of change and they are looking for partners, but the migration from implicit to explicit costs has done nothing to help dealers justify their value propositon to the buy-side.

If the economics of trading swaps don’t add up, the buy-side will stop trading them. A dip in liquidity, at least for the short to medium-term is a near certainty. Many will take a wait and see approach come implementation day, happier to stand on the sidelines to avoid potential disruptions in pricing, clearing, and perhaps the system as a whole. Opportunists will do the same, on the look out for anomalies that they can arbitrage. What happens in the long term is less clear. Futures will be a beneficiary, and the buy-side will have to learn how to handle basis risk. The more vanilla, short term swap contracts will trade in small size in the new SEF environment successfully, and will start to trade continuously, rather than by Request-for-Trade (RFQ). There may be a filter down effect over time into less liquid swaps but, for bilaterally-negotiated trades that they cannot do without, the buy-side will simply have to bear the costs.

If cross margining efficiencies can be found and the collateral burden reduced, trade activity will increase. If an FCM comes to market with a truly competitive pricing scheme, the connection between clearing and execution will be broken, and new competitive elements and business models can start to be applied. Only with the introduction of technology-focussed principal trading groups and a truly agency execution framework, can we expect to see a compression in bid/offer spreads and growth in trade volumes to counteract today’s negative sentiments.

US Buy-Side Swaps Trading 2012 : I Can See Clearly Now
US Buy-side Swaps Trading 2012 is our first annual study, and results from conversations with 31 firms, comprising asset managers, hedge funds, banks and insurance companies dealing in interest rate swaps and/or CDS. Nearly half of the firms we spoke to were asset managers, roughly a third were hedge funds, and the balance was split evenly between banks and insurance companies. The banks we spoke to were regional, with trading desks responsible for discretionary investment portfolios. At insurance companies we spoke to treasury trading operations responsible for managing both the duration risk of their customer portfolios as well as using derivatives to maximise returns on their capital base. Many of the asset managers and hedge funds ran OTC swaps portfolios to manage the risk on, as well as generate alpha for, their fixed income portfolios. 61% of the participants traded all instruments, while 19% were solely focussed on the credit markets, 10% traded swaps only, 6% used only futures and swaps, and 6% just traded rates.