Implementation of the Dodd-Frank legislation mandating new rules for trading credit default swaps and other OTC derivatives presents a unique opportunity to strengthen the global credit markets following one of the most devastating collapses of liquidity in economic history. Electronic trading can play a key role in accomplishing this objective.
The experience of other markets that have embraced electronic trading, including MarketAxess’s own experience as the leading electronic trading platform for corporate bonds, foreshadows the many benefits that the right reforms could bring to CDS trading:
● Investors have typically seen transaction costs decline with the growth of electronic trading as a result of increased competition among dealers and greater market transparency;
● Dealers have been able to expand their base of investor clients while simultaneously reducing costs associated with manual trading and trade processing;
● Automated processing has slashed the number of trade errors and the expense associated with trade cancellations and corrections;
● Electronic audit trails and compliance tools let investment managers meet their fiduciary duties to confirm “best execution” with increasing confidence;
● These benefits have ultimately led to increased market efficiency, participation and fairness.
Our goal should be to extend these improvements in both the bond and OTC derivatives markets.
In addition to cost and operational efficiencies, increased price transparency through improved dissemination of market information has generally followed on the heels of electronic trading. For example, one of the catalysts to MarketAxess’s growth was our publication, even before the TRACE facility became a reality, of information regarding trades that occurred on the MarketAxess platform. Today, electronic trades in corporate bonds completed on the MarketAxess trading system are typically reported publicly on the FINRA TRACE tape within one minute of execution. Likewise, with central trading facilities for CDS, public reporting of all standardised CDS trades can happen quickly and efficiently.
Increased transparency not only allows market participants and regulatory authorities to better understand and manage risk in real time, it also allows new market participants to enter financial markets on a level playing field. The introduction of FINRA’s TRACE reporting system for the corporate bond market resulted in a fairer, more competitive marketplace for all participants. Market transparency, greater competition and central clearing have in turn played significant roles in allowing the corporate bond market to recover from the crisis much more quickly than the CDS and structured product markets.
One other likely benefit of CDS reform has received little attention in the current discussion: a more transparent, centrally cleared CDS market may significantly expand the number of participants in the market for OTC credit products. This outcome would be healthy for global credit markets as well as the global economy.
Primarily because of the CDS market’s bilateral credit risk, onerous documentation and opacity, traditional asset managers have typically not been active participants. Yet it is reasonable to expect that these fiduciaries will seize upon the opportunity to participate in a transparent, centrally cleared market with the operational safeguards and efficiencies inherent in electronic trading. It is also reasonable to expect that a wider group of dealers will deem it possible to profitably enter the market, thereby providing a larger, more diverse and competitive pool of liquidity. Such trends would strengthen both the cash and the derivatives credit markets.
Institutions with large, long-term holdings of credit instruments could realise significant advantages in managing their portfolios by using CDS strategies to hedge positions and more efficiently adjust exposures as they manage flows of funds. They may join in the tendency to view the cash market and the CDS market as a part of a continuum of asset choices in the global credit market. Over time, regulatory regimes may adjust to allow them to do so with more flexibility.
It is not difficult to see how such an environment would help deliver more cost-effective investments for fiduciaries and individuals. For example, it’s worth asking how much more efficiently the $65 billion in corporate bond exchange-traded funds could be managed should its investment advisors have access to a derivatives marketplace that would let them adjust exposures using transparently priced, centrally cleared derivatives. This could have a positive impact on both the cost of managing these indexed portfolios and the funds’ ability to track relevant benchmarks.
To realise these benefits, we believe that the new regulatory environment for CDS should reflect three principles:
First, the new rules should embrace an expansive definition of standardised instruments, one that reflects the diversity of OTC credit market instruments in the institutional markets. Based on available DTCC warehouse data, approximately 75% of CDS volume takes place in actively traded indices and single names. These swap contracts should fall under the definition of standardised instruments. A narrow definition of standardised products would limit the usefulness of the CDS market and undermine the objectives of the reforms.
Second, the new rules should encourage electronic trading protocols appropriate to the diverse nature of both the cash bond market and CDS credit instruments and promote participation by a wide range of liquidity providers and investors. The myriad varieties of instruments and the uneven liquidity in the credit markets make an exchange model impractical for all but the few most liquid CDS contracts. It is instructive in this regard that although exchange trading has been available for corporate bonds on the NYSE since the late 1970s, exchange trading of corporate bonds has never developed any meaningful liquidity.
But a request-for-quote or auction approach, similar to that used successfully by MarketAxess for corporate bonds, can deliver competitive pricing, pre-trade analysis and post-trade settlement and processing for the vast array of products in both cash and derivatives trading between institutions and dealers. As appropriate trading protocols are considered, it is important to allow market participants to decide where they are best served from a liquidity and efficiency standpoint as long as the electronic trading protocols meet the stated objectives of the regulatory reform bill.
Third, the rules for swap execution facilities (SEFs) should be carefully drawn to ensure that these trading platforms are independent, well governed, financially sound and broadly accessible to qualified institutional players. Similarly, regulated clearing institutions and market standard data sources must be broadly accessible to SEFs and independently governed in the best interests of the market as a whole.
Building the right structure for the CDS market is critical to restoring confidence and proper functioning to the global credit markets. And strong credit markets are, in turn, an essential part of restoring growth to the global economy. Electronic trading can play an important role in achieving more accessible, transparent, competitive and efficient CDS and bond markets. Leveraging the proven benefits of electronic trading should be an integral part of implementing CDS reform.
By Richard M. McVey, Chairman and CEO, MarketAxess Holdings Inc.