Credit market participants should begin preparing for the transition to electronic trading which will be an inevitable consequence of Dodd-Frank reform, as Richard McVey of MarketAxess outlines in this Q&A.
Q: What changes are starting to take place in the OTC derivatives market as a result of Dodd-Frank regulatory reform?
A: The OTC derivatives market is not waiting for the legislative deadline for new rules, but is rather moving ahead to establish electronic trading and central clearing for a significant range of instruments. For that reason, MarketAxess continues to make enhancements to the MarketAxess CDS trading system, expand our pre- and post-trade connectivity capabilities, and facilitate CDS trading relationships in anticipation of an upswing in electronic trading well ahead of the regulatory mandate, particularly in more liquid swap contracts.
Meanwhile, U.S. regulators are pressing ahead on the three key changes mandated by Dodd-Frank legislation that will transform the OTC derivatives market: central clearing for standardized swaps; the requirement to trade standardized swaps on an exchange or “swap execution facility” (SEF); and increased pre- and post-transparency. Regulators have mandated central clearing for standardized swaps, and now need to finalize the rules by mid-July. Once the final rules are adopted, there will be a grace period before they become effective. As an independently governed firm with proven electronic trading capabilities for the credit markets, we anticipate we will be able to meet all of the regulatory requirements for operating an SEF.
Q: What do industry participants need to do to meet the requirements within the timetable?
A: Given the legislative deadlines, there is a daunting amount of infrastructure that needs to be put in place in order for the market to function within the framework envisioned by the regulators. Simply put, Dodd-Frank requires a substantial amount of connectivity between counterparties and through clearinghouses, exchanges, SEFs and swap data repositories, among others. These hurdles are not insurmountable, especially when one looks more closely at areas of existing connectivity between counterparties and service providers that can be leveraged. However, the industry needs to come to a consensus on how that will all work.
In the meantime, MarketAxess is urging investors to begin taking steps now to prepare for the new regulatory mandate. Investors should carefully consider their choices of central counterparty clearing houses (CCPs), prime brokers, futures commission merchants (FCMs), and SEFs so they can get clearing agreements in place and establish connectivity necessary to begin testing.
Q: What products do you expect to most easily shift to electronic trading, and how much of the swaps market will trade bilaterally, on exchanges or on SEFs?
A: The opportunity for electronic trading of OTC derivatives is potentially large, depending on how regulators define which swaps are standardized and must be centrally cleared. Those swaps that are considered standardized must be traded on an exchange or an SEF. With respect to CDS, we believe the CDS indices and the single-name components of the major indices are likely to be centrally cleared and standardized. Swaps that trade infrequently or are highly structured are less likely to trade electronically and more likely to continue to trade bilaterally.
Based on DTCC trade warehouse and other publicly available data, the current total average daily trading volume in the global CDS market is over $100 billion in notional value, including indices and single-name CDS. Looking deeper into the market data, we believe at least 75% of the daily CDS trading volume is likely to fall within the definition of standardized, clearable swaps that would have to be traded on an exchange or through an SEF.
While it is conceivable that on-the-run indices might have the liquidity and market depth to allow for exchange trading or trading in a central limit order book, most CDS single-names are too illiquid to trade like equities or listed futures and options contracts. From our experience in providing trading technology for other less liquid asset classes – namely, corporate bonds – dealers and investors tend to prefer request-for-quote (RFQ) trading protocols. Given the range of liquidity across the CDS market, MarketAxess is prepared to offer both RFQ and central limit order book trading protocols.
Q: Will regulatory changes in the OTC derivatives market for CDS affect the cash credit market and its uptake of electronic trading?
A: MarketAxess is already beginning to see broader recognition that electronic trading is going to be a major part of the credit markets going forward. For U.S. high grade corporate bonds, we experienced a significant increase in market share in 2010 when trading volumes across the platform were up 30% in a year where TRACE market volumes were essentially flat.
As the derivatives market prepares for significant market structure changes by way of Dodd-Frank, we believe there will be a knock-on effect for electronic trading in the cash markets. On MarketAxess, investors can trade both liquid and illiquid credit derivatives, while maintaining their cash bond business over the same platform. MarketAxess is uniquely positioned to offer basis trading between cash and CDS, given our role as the leading e-trading platform for corporate bonds.
Q: Are there substantial differences between the proposed rules of the CFTC and the SEC?
A: For the CDS market, the CFTC and the SEC both have an important role to play. The SEC has jurisdiction over the CDS single-name market while the CFTC will regulate the index market. In most respects, the SEC and CFTC rule proposals are very similar. The SEC’s proposed rules do, however, allow for some greater flexibility in the trading protocols, and do not require participants to send RFQs to a minimum of five market-makers as required under the CFTC proposals. This greater flexibility for single-name CDS trades makes sense as they trade less actively than the indices, reflecting the fact that there is generally less liquidity in the single-name contracts.
It is our hope that the final rules allow market participants sufficient flexibility to be able to trade using protocols they feel are most appropriate for their specific needs and for the particular instrument being traded. The experience to date strongly suggests that one size does not fit all and regulatory rules should be flexible enough to recognize key differences in trading activity and liquidity among various instruments and asset classes.
Q: How will the proposed rules on market transparency impact the swap markets?
A: MarketAxess believes the CDS market will greatly benefit from increased pre- and post-trade transparency that will allow participants to better understand and manage risk, and create a more competitive, fair playing field that will expand participation in the market. However, it’s very important for our dealer and investor customers that the regulators set the rules in a sensible way around block trading and block trade reporting. MarketAxess believes different block trade size thresholds should be considered by the SEC and the CFTC depending on the volume and frequency of trading in a contract so that increased transparency does not negatively impact market making capabilities and liquidity in the market. For instance, the average trade size for an index is about five times the size of single-name trades and needs to be taken into consideration when establishing the final rules on block trade size thresholds. Any trade that is likely to require a dealer more than a full day of trading to offset the dealer’s risk should be considered a block trade and not be subject to immediate price reporting. In this regard, FINRA TRACE reporting rules for high grade corporate bonds, which do not report the actual size of trades above $5 million, may serve as a useful model for standardized swaps.
Q: What are the parallels and differences between market structure reform taking place in Europe compared to the U.S.?
A: There are many parallels between the regulatory reform discussions in the U.S. and Europe. However, while regulatory changes in the U.S. are principally focused on the derivatives markets, in Europe, the reform process is looking more broadly at transparency, business conduct rules and trade execution venues across all financial markets.
At this point, the reform process in Europe seems to be primarily focused on central clearing and transparency as opposed to trade execution. It will be important for regulators to synchronize their rules as most derivatives trading today takes place through global institutions that have flexibility in choosing the geographic location for their trading and clearing.
Richard M. McVey
Chairman and CEO
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