Transparency premium: insurers seek swaps reporting reform

US insurers claim their bespoke swaps are being front-run, raising hedging costs

  • US derivatives users are required to report derivatives trades to a swap data repository (SDR) within 15 minutes of execution.
  • US insurers claim their trades are too easily identifiable on the SDR due to the distinct and often less liquid instruments they use for hedging risks.
  • They argue this allows some market participants to move the market before the executing dealer has got out of the risk.
  • This creates extra trading costs for dealers, which say they pass this on to clients through a wider bid/offer spread.
  • Insurers are lobbying the Commodity Futures Trading Commission to introduce time delays for reporting illiquid trades, reigniting the debate about the costs of transparency.

Something strange has been happening on the derivatives trading desks of US insurance companies in recent years. When executing a bespoke product such as a long-dated forward starting swap, a request for quote (RFQ) is sent to dealers, prices are received and the trade is executed in the normal fashion. Then, 15 minutes later, the phone rings. A bank salesperson would like to know why the insurance company didn’t execute the trade with them – even though they weren’t in the RFQ

The timing of the phone call, shortly after the trade is reported to a repository, leaves one insurer’s trader with little doubt about what is happening. 

“We’ve had dealers calling round, even when we’re not involved, asking if we’ve just done this or that trade – and it’s because they’ve just seen it come up on the swap data repository [SDR],” says a derivatives trader at one large US insurer. 

Under the US Commodity Futures Trading Commission’s (CFTC) part 43 rule, which stems from the Dodd-Frank Act and ultimately the Group of 20 nations communiqué from the 2009 Pittsburgh meeting, swap transactions need to be reported “as soon as technologically practicable” after execution, which has been set at a maximum of 15 minutes. European rules, on the other hand, allow reporting the day after execution – although that is set to change from next year (see box: Reporting in Europe).

Although the reported data does not include names of counterparties, the distinct and infrequent nature of insurance trades means they tend to be easily identifiable when they hit the tape. 

An occasional unsolicited call from a sales desk is little more than a nuisance, of course. But insurers say there is a murkier aspect to the phenomenon. They are convinced the banks’ data mining of the SDR is also affecting market behaviour, with canny players using the data to move the market before an executing dealer can get out of the risk, pushing up their trading costs. One insurance industry body is already understood to have raised the issue with the CFTC.

Incoming CFTC chairman Christopher Giancarlo has made clear his intention to review the reporting requirements for derivatives users, leaving insurers hopeful the regulator will address the issue in the near future. The CFTC confirmed discussions with representatives from the US insurance industry, but declined to comment further. 

“The banks have turned data mining of the SDR into a cottage industry,” says the derivatives trader at the US insurer. “The insurance industry has been talking directly with Chris Giancarlo and his staff about delays to reporting. It hurts both the buy and the sell side – and I think he understands that.”

Loss of anonymity 

Concerns about the possible unintended consequences of swap market transparency have been voiced a number of times before. Darrell Duffie, Dean Witter distinguished professor of finance at Stanford University’s Graduate School of Business, recalls many conversations with markets and prudential regulators about the issue at the time Dodd-Frank was being drafted. 

“There were lots of discussions around what would be the appropriate way to treat the disclosure of positions,” says Duffie. “That was in light of the fact that when large positions are executed, and there is significant disclosure about the size or price or both, then it is going to be harder for the dealer to lay off that position. The suggestion was that the buy side might suffer from a cost imposed by the dealer due to costs for them in laying it off.”

To address this, the CFTC introduced reporting time delays for block size and large notional off-platform trades in the final draft of the part 43 rule. The problem remained for those trading bilaterally under block size in illiquid markets, though. 

darrell-duffie-2017
Darrell Duffie: Concerns over unintended consequences

This was highlighted by Dallas-based Southwest Airlines in 2013. Its multi-year fuel hedging strategy takes the firm into some very shallow parts of energy derivatives markets. Thanks to persistent lobbying efforts, the commission issued a no-action letter to the airline on November 6, 2014. Trades executed by the airline longer than 24 months in duration, where trades in the oil market are relatively infrequent, were permitted to be reported to an SDR 15 calendar days after execution, instead of within 15 minutes. 

Insurers are adamant they face a similar challenge to Southwest Airlines, given they also need to hedge on a regular basis in some very illiquid parts of the market. 

For example, long-dated, forward-starting interest rate swaps – derivatives that begin on a predetermined date in the future – are used widely by life insurers to hedge changes in interest rates affecting future cashflows, but are traded infrequently.

Insurers are also users of long-dated variance swaps, which give a payout equal to the difference between realised variance of an equity index and a pre-agreed strike level, multiplied by the vega notional. Vega is the sensitivity of an option’s price to changes in volatility.

Writing variable annuity products on the S&P 500 requires insurers to sell out-of-the-money long-term options, which leaves them short vega on the index. Buying a variance swap on the index hedges the position by giving the insurer long vega exposure, and can come cheap, as dealers’ structured product flows often give them an axe to sell the swaps. 

But since the introduction of real-time reporting, insurers say they have encountered exactly the same problems entering illiquid derivatives trades that Southwest Airlines faced when hedging oil and jet fuel with longer-tenor instruments. 

Carey Hobbs, senior vice-president and head of market risk management at Lincoln Financial Group in Philadelphia, gives the example of a long-dated vega trade, which would be more typical of an insurer. “It wouldn’t be unusual to need to leg into a larger vega trade with smaller trades,” he says. “But what happens now is that everybody else on the Street sees the trade and they bid vol up.”

Winner’s curse

Terry Leitch, a principal at Ruxton Advisors and former derivatives trader at Aegon in Baltimore, says dealers have raised the issue with him on numerous occasions. One bank he spoke to claimed lower-tier competitors, perhaps lacking the capital to take advantage themselves, routinely take positions based on what appears on the SDR before distributing to hedge funds in return for a small margin. 

“A bank source told me this can be a major difficulty for them when taking on large programme trades from insurers,” says Leitch, who is creating SDR surveillance tools for the CFTC’s Office of the Chief Economist. “They basically get run over once the trade hits the tape. Other banks see it [on the SDR] and then they start calling the hedge funds.”

The SDR has exacerbated this ‘winner’s curse’ problem. There was always one before, but it’s more problematic given that trades are reported as soon as practical now
Derivatives trader at a US insurer

The derivatives trader at a US insurer tells another story of a dealer counterparty that suffered a significant loss when trying to hedge the delta risk of a trade it had just executed. Attempting to hedge the risk directly with swaps, instead of a more liquid but less accurate hedge such as futures, the dealer was unable to find offsetting positions in time before the initial trade appeared on the SDR, and the market moved.

“They lost money because of the way they chose to hedge,” he says. “In cases like that, we are not really sympathetic, because we had given them half an hour to get off their delta risk. They should have been able to get it done. 

“The SDR has exacerbated this ‘winner’s curse’ problem,” he adds. “There was always one before, but it’s more problematic given that trades are reported as soon as practical now.”

The price of transparency

Unfortunately for insurers, what begins as a hedging loss for the sell side often translates in the long run into higher trading costs for the buy side. Knowing the market is likely to move once details of a less liquid trade with an insurer are published on the SDR, dealers will typically reflect their increased hedging costs in the bid/offer spread offered to end-users. 

“Ultimately, this results in a wider price for the client,” says a senior rates trader at one European bank in New York. “Every time you print, everyone knows you’ve printed, so you start from a disadvantageous position. If every time you print a trade with an insurer your hedge becomes more expensive, you have no choice but to widen the price for the client.”

In his testimony before a House of Representatives subcommittee in 2013, Southwest Airlines treasurer Chris Monroe claimed SDR reporting of its trades widened its bid/offer spread by 35 basis points. 

At a certain point, people will simply say they don’t want the price offered, and they will back out of the trade
Carey Hobbs, Lincoln Financial Group

“Applying an additional 35bp in the cost to typical volumes traded by Southwest – in illiquid areas of the crude curve and in illiquid products such as jet fuel – will add roughly $60 million in annual costs,” he told the committee.

Insurers believe the impact on pricing may also be helping to feed into the low liquidity seen in certain segments of the market. In markets where extremely adverse post-reporting price movements are expected, dealers may refrain from offering a price to begin with. Insurers, equally, might decide they do not want the trade at the price the dealer has offered. 

“This certainly affects pricing indication on the trade,” says Lincoln Financial’s Hobbs. “But it also affects inclination. At a certain point, people will simply say they don’t want the price offered, and they will back out of the trade.”

“What I do, and what most people do, is wait it out a bit,” he adds. “Also, I’m fortunate in a sense because we deal in relatively liquid markets. We are trading US rates and equity at very liquid points. So if I’m running into something I don’t want in one particular trade, I can try to replicate that with another trade instead.” 

Calls for reform

In January 2017, the Republican controlled House of Representatives passed a CFTC reauthorisation bill that included a provision effectively allowing the Southwest Airlines no-action letter to continue. 

This offers some hope to insurance firms, which feel it is unfair they have not been granted similar treatment by the CFTC

“One insurer complained some commodity hedgers, for example an airline hedging jet fuel purchases, get an end-user exception,” says Ruxton Advisors’ Leitch. “He feels the situation is similar and wonders why the insurance industry doesn’t get an exception as well for these big rates programmes.”

However, extending no-action letter relief to a wider array of firms such as insurance companies would not necessarily be everybody’s preferred outcome. Some insurers are hoping the CFTC will go much further and fully revise the rules on real-time reporting. 

“We would be looking to change the CFTC rules – not just a no-action letter,” says the US insurer’s derivatives trader. “It was a poorly designed rule, based on the notion that retail participates in the derivatives market and therefore we need everything transparent pre-trade. Our argument has always been that if you are so unsophisticated that you don’t know where the markets are before you trade, you probably shouldn’t be using derivatives.”

Terry Leitch
One insurer complained some commodity hedgers, for example an airline hedging jet fuel purchases, get an end-user exception. He feels the situation is similar and wonders why the insurance industry doesn’t get an exception as well for these big rates programmes
Terry Leitch, Ruxton Advisors

The CFTC’s Giancarlo is a known advocate of a less prescriptive approach to financial regulation. But while his new Project Kiss initiative – which stands for Keep It Simple, Stupid – is set to alleviate some of the burden of derivatives regulation, it stops short of what insurers would like to see. 

Ruxton Advisors’ Leitch says that if the insurance industry wants more it will need to keep pushing the CFTC to keep the issue on the regulatory agenda. 

“They are aware [at the CFTC],” he says. “But given all the competing priorities at the present time, the industry would need to take the lead if they want any kind of supporting analysis.”

Giuseppe Nuti, head of US rates trading at UBS in New York, says the CFTC will ultimately have to strike a very delicate balance in any revision of the reporting rules. He believes the timely dissemination of trade information has been helpful in terms of price discovery, and has achieved the regulators’ stated aim of making derivatives markets more transparent. On the other hand though, it is evident that for some trades, that information can be market-moving. 

“We are all for transparency,” says Nuti. “But we are also all for a competitive and tight bid/offer pricing for our clients and sometimes, like in this case, those two things can be conflicting requirements. That transparency is the source of the winner’s curse, and you cannot have both.” 

Reporting in Europe

14-european-commission-sunshine-timeline-large

In the European Union, the European Market Infrastructure Regulation requires over-the-counter derivatives trades to be reported by the end of the day following execution, known as  T+1, instead of within 15 minutes like the US. But this will change with the introduction of the second Markets in Financial Instruments Directive (Mifid II) in 2018, which will require certain OTC derivatives transactions to be reported within 15 minutes.  

The regulation will not capture all derivatives trades, however. National competent authorities are permitted under the rules to waive reporting obligations according to certain criteria, the first being if the transaction is large-in-scale compared with normal market size. The second is if the size of the trade is above a threshold specific to the instrument being traded, and the dealer is taking principal risk rather than executing on an agency or matched principal basis. 

Finally, reporting rules can be waived if the instrument has an illiquid market – a principle that should minimise the risk of the same reporting-driven market movements seen in US markets.

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