By: Julian Fisher
The center cannot hold! The day of banks making over-size profits from trading OTC derivatives, which comprised some 37% of banking revenue in 2010, is over. Regulatory forces, in the form of Dodd-Frank, EMiR and MiFIR in Europe and similar regulations in Asia, will have tectonic consequences on the financial markets that will send tremors far beyond the OTC derivatives space. Product and Geographic contagion will spread as Europe, buoyed by the Dodd Frank initiative in the US, seeks to impose a transparent equities-style market on all types of fixed-income trading markets. With the desire to eliminate regulatory arbitrage opportunities, increasing proportions of electronically executed volumes will soon be seen in cash and related products and, as the cost of trading derivatives increases, flow will be driven to the lower cost futures markets.
This shift of banks from a principal to an agency role will happen quicker than most imagine as Centralized Clearing Counterparties (CCPs) and Execution Facilities (SEFs, MTFs, Regulated Markets) are incentivized to make products available to trade quickly, forcing banks to trade these products electronically and transparently. Margin charges for uncleared trades, currently estimated to be at least three times the charge for cleared trades, will speed the need for electronic trading adoption. Clients will be willing to trade-off structural mismatches via substitute financial products against the higher costs of perfectly hedging their risk via a costly unclearable trade. Increased capital charges, levied through the Basle 3 directive, will make trading of uncleared trades overly prohibitive. The cumulative effect of all these changes will be that, by 2014, a 2010 study by Citi cites that 60% of all current OTC derivatives could be mandatorily clearable and executable through anonymous markets.
The aftershock of these tectonic forces will cause the interdealer markets to cease to exist as we know them. SEC & CFTC rules will require the same prices to be made available to all market participants, with no discretion and limited ability to price differentiate by customer. This transparency will drive spreads lower. Whilst the principal/ client relationship will be significantly curtailed, “block orders” for clearable and executable products will still be allowed to be voice executed with banks acting as principal.
The impact of these regulations on bank trading staff is already evident. Commodities traders have left Goldman Sachs in their droves as they migrate to the less regulatory shackled and better paying hedge funds. This is just the tip of the iceberg as the exodus of traders looks set to pick up steam, driven by shrinking profits and tighter regulation.
The effect on the Derivatives Old Boys Club, where the fourteen largest global derivatives dealers account for 82 percent of the total $600 trillion market, will be transformative. .
Price transparency, fragmented execution venues and decreases in deal size will attract new entrants. A widening participant base will further promote liquidity, whilst driving profitability lower through decreasing spreads. As liquidity increases markets will move from a Request For Quote (RFQ) to a Central Limit Order Book (CLOB) modality where spreads, and profitability, are compressed further. Once liquid swap benchmarks move to a futures style CLOB, there is no question that high frequency trading will result. Algo trading in swaps are likely to focus on the short end of the curve with notional sizes of $10m or less, following the pattern seen in the electronic transformation of equities and foreign exchange.
Hedge Funds, whilst benefiting from less severe restrictions than banks, will not get a free ride. The largest may be forced to register as Major Swap Participants, incurring increased regulatory driven transparency, risk management and collateral demands Even as Funds welcome the migrating swap traders it is likely that many mid-tier funds will disappear altogether unable to compete in this new capital intensive, leverage reduced landscape.
Commercial users will also be impacted by the increasing costs of derivative trades, even though they are exempt from mandatory swap execution and clearing requirements (and hence initial margin requirements), as dealers will pass on extra charges to end users.
Price, liquidity and transparency will no longer be drivers of order flow to banks. As profit margins shrink and anonymous trading becomes the norm the differentiators for success will change following the degradation of the principal/ client relationship. A number of partial offsets in the form of new revenue streams including Collateral transformation, margining and financing are likely to become a more explicit part of the business. Clearing fees will likely emerge as a material sources of value. From a service perspective, access to capital issuance and content are likely to take a more prominent role as they do today in the equities business. However these ancillary services will not be sufficient to fully buffer the loss in profitability of the derivatives business.
For a business dominated by TLAs (Three Letter Acronyms) such as IRS, CDS and CDO, one TLA is noticeably absent from the major swap players lexicon, ABC – Activity Based Costing. Many of the leading players are ill equipped to determine the cost of their derivatives business and, hence, understand how profitable their swaps business will be going forward. This will undoubtedly lead to players underestimating their total swap trading cost basis and result in further erosion of profits.
The electronifcation of the OTC derivatives market may cause total bank revenues to drop 10% over the next 2 years due to spread and profit compression, this drop may being compounded by contagion risk to bilaterally traded, non-derivative, products. As trading becomes commoditized, consolidation will occur as the top players turn themselves into flow monsters in order to grab economies of scale, squeezing out the mid-tier players. Ironically the same regulations designed to eliminate the too big to fail paradigm may have created one in which many are too small to succeed.
Julian Fisher is an Executive Director of Crest Rider (www.crestrider.com), a risk management consultancy dedicated to providing Financial Institutions with Regulatory and Risk consulting services