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Key Changes Driving Capital Markets

Progress and change in financial services businesses come from a stirred mix of regulation, technology and creativity — with powerful interests in the status quo usually dragging on the spoon.

The first ingredient, regulation, has been the most important since the financial crisis, and the end effects of the global drive in this area are only now beginning to be felt as the first rules on execution from the Dodd-Frank and EMIR processes come into effect in the U.S. and Europe. Much detail in these regulations (and also Europe’s yet-to-be-agreed MiFID II framework) remains to be finalized, but we have drawn the following broad conclusions:

  • OTC derivatives and fixed income will be the most heavily affected asset classes. Europe has a vital role in the future of trading OTC derivatives and fixed income, given the concentration of OTC business in London in particular (47 percent of global interest rate derivative trading, according to the most recent Bank of International Settlements Survey figures). 
  • As with any change, while there will be winners and losers, there are significant gains for first movers and certain infrastructure providers, and the broker-dealer community as a whole must expect its margins to come under further pressure. 
  • A serious worry about the sudden imposition of heavy and prescriptive regulation on the OTC markets is inconsistency between the major regulators. There is risk that timing, detailed content and concerns about extraterritoriality will lead to regulatory arbitrage. 

Amidst all the changes, swaps trading is a particular area of focus, especially since there are massive changes underway in the OTC derivatives markets which are predominantly regulation-driven. Given the relatively low transaction volumes, all swaps traders will not have the incentive for major technology-based innovation to lead change, but for all, innovation is required to continue to participate in these markets. The primary impacts of the drivers towards clearing and ‘organized’ trading appear clear: there will be a move from principal to agency trading, and collateral requirements for margin demands will be significant.

This shift from principal to agency trading is already on the rise, and swap market participants must adjust to working in a new exchange-based market structure, although with important differences that reflect the different liquidity. $600 trillion in outstanding OTC derivative notional value indicates a huge market, but estimated transaction rates are much less impressive. If we consider interest rate derivatives, which account for more than 75 percent of the OTC market, then average trade size of $200+ million and daily turnover of $2-3 trillion indicate only some 10,000 trades per day: a tiny number by listed market standards. Of course, trade sizes in the cleared and electronically traded (and largest) part of the new market are likely to become much smaller, so that meaningful levels of liquidity should be achievable on many venues. Therefore, the role of broker-dealers will increasingly need to be an agency one, enabling connectivity and access to liquidity in a multi-channel landscape of trading venues: the SEFs and OTFs demanded by U.S. and EU regulations.

Collateral requirements to support margin demands, in both the cleared and bilateral sectors, will be high: estimates range up to an additional $10 trillion (even that of the central bankers’ relevant committee runs to $4 trillion). Consensus seems to be that enough assets of the necessary quality can be found to meet this requirement, but tight and optimized management of the relevant asset pools will be required.

The listed derivatives markets have already benefited from the uncertainties and expected cost increases in the OTC world. The launches of additional swap futures and other contracts aimed at creating economic equivalents or near-equivalents to major OTC derivatives have been well publicized, as have the ongoing battles about a skewed regulatory playing field for the two sides. There is still much to be settled in this contest: we can expect some substitution of OTC contracts by current and new listed instruments, counterbalanced by the limitations of futures for long-term hedging purposes (such as rollover risk and their different accounting treatment under FASB rules).

The cash fixed income market change has different drivers, but some of the end effects will be very similar to those in the swaps market. While there are clear regulatory impacts (from the Basel capital limits, the U.S. Volcker Rule’s proscription on proprietary trading and MiFID II’s stress on market transparency) notably there is also a widespread business sense that the time has come for electronic trading to play a larger role in improving efficiency in this vital asset class. Numerous electronic trading venues have been set up in recent years: perhaps too many to be sustained by the market, which is relatively illiquid at the individual issue level. Fragmentation is a recognized problem, and initiatives for the development of better market linkages are being driven by major buy- and sell-side firms.

The buy-side has already taken on a much higher proportion of balance-sheet risk from the sell-side: inventories at the big U.S. banks have fallen by more than 75 percent from their 2008 peak, and holding periods for block-sized trades are now a week or two, where three to six months was once common. Indeed, there is recognition that this will need to go further—while sell-side capital will still be required to oil the trading wheels, the future role of today’s dealers (as in the swaps market) will look more like that of an agency broker. That this fundamental structural change is being pursued by the market itself, with an apparent sense of urgency, is of course partly due to the sense of needing to jump before being pushed by the regulators.

Individual firms’ concerns will naturally center on managing the many complex changes that are forced upon them and the consequent revenue and cost impacts. This process will be made more difficult for global players by the inconsistencies in approach and timescales between the various jurisdictions, or “regulatory balkanization” to quote a Morgan Stanley/Oliver Wyman report.

Other current worries include the concern that there may not truly be enough collateral out there to pass a true test when markets are under significant stress. European regulators are simultaneously cracking down on the securities lending markets by restricting re-hypothecation and profit allocation. Fortunately, the lobby behind the Financial Transaction Tax is now in retreat—perhaps regulators are now recognizing that it would likely be dangerous to pull all the levers at the same time.

The new OTC market environment will have its own group of potentially weak links that are ‘too big to fail’ -- the CCPs. Eventually, regulators will have to test the unattractive range of choices for the handling of a clearing house failure. Furthermore, some CCPs will not be big: many single-country clearers are in plan or build mode to compete with the large international CCPs, and collateral risks being fragmented across 20-25 entities globally.

Over the next two to three years, large tranches of global swap and fixed income trading will be transformed in broadly similar directions. As with other increasingly electronic markets, they will resemble one another more closely, and will also look more like today’s listed markets.


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