Look for the banks to register individually as "swap execution facilities" to protect their big derivatives trading revenues they garner through trading derivatives individually, or bi-laterally, with each of their customers in single, one-off transactions, even though the banks are not publicly saying they will do.
As we said back in July, despite the passage of the "Dodd-Frank Wall Street Reform and Consumer Protection Act," it's the same as it ever was regarding swaps trading, meaning these derivatives, which include interest rate and credit default swaps, will be traded the same ways they always have, including, most often, between a single bank and its counterparty over the phone.
While various mainstream news media have blithely proclaimed (and some still do) that the financial reform law passed in the wake of one of the worst market implosions in our history would push derivatives onto exchanges with multiple bidders and multiple pricing offers, or electronic trading systems where participants must request pricing quotes from multiple banks - some of which the bill appears to call "swap execution facilities" or "SEFs" - that couldn't be further from the truth.
That's not even contemplated by a reading of the Act. And it's certainly not contemplated in the definition of SEF that's being formulated in the closed-door "advisory" sesssions going on between the industry and the Commodity Futures Trading Commission and the Securities and Exchange Commission, the regulators tasked with defining such Dodd-Frank specifics, including SEFs.
Here's the proof, courtesy of MarkitSERV, a joint venture between the Depository Trust and Clearing Corporation (DTCC), The Street's giant utility for processing and settling securities, and Markit, which is owned by the biggest swaps trading banks and is the sector's pricing and data provider; it operates the well-known and most traded benchmark credit default swaps (CDS) indices, which account for about half of all CDS volume. Search "non-multiple" in the aforementioned and "1-to-many" in this document to understand that The Street is setting the agenda for defining SEFs, including as single-bank systems.
Under the law, according to this interpretation, each bank - the "1" in the aforementioned "1-to-many" phrase - can individually be considered a SEF, by providing pricing to multiple - the "many" in said phrase - customers, or mutual fund firms and the like, known collectively as "the buy-side." The bank is the "sell-side." So this interpretation of a swap execution facility includes one in which only one sell-side bank is offering derivatives prices to either multiple buy-side institutions, or other (multiple) banks. This is way different from a typical exchange system, which is "many-to-many," meaning multiple brokers (or banks) offering prices and bids on stocks to multiple buyers and sellers, meaning institutional investors, which are, again, often collectively known in the industry as "the buy-side," many of which manage our money: An example is a big mutual funds operator like Vanguard. Note that only brokers (or banks) - the sell-side - are allowed to execute trades directly on an exchange: Buy-side firms like Vanguard must trade through a broker or bank, or use a broker or bank, to trade.
Background: From nearly the start of debate over financial reform, the banks and their attorneys, including those at several of their major swaps data processing providers, have said that “single-bank” swaps trading systems would fit the definition of a SEF. Why? Well, we'll answer that with several questions: Why would a bank give up profits via a mode of execution that arguably can optimally enable those profits? Why would a bank give up a mode of execution that best promotes the bank and its own brand? Why would a bank give up any method of trading in which it makes ample revenues? Perhaps more pointedly, why would a bank give up all its single-bank execution business to competitors including exchanges, multi-bank electronic trading systems or inter-dealer brokers (the latter firms act as "brokers' brokers," or middlemen for the banks, in that they match trades between banks)?
The answers to all of these: They wouldn't. And they didn't. And they won't.
A bank likes trading with a counterparty through its own "single-bank" or "single-dealer" proprietary system because it enables the bank to have optimum control over marketing, sales and ultimately and crucially, pricing of whatever product's being traded.
Let's start with CDS: In current practice, details of CDS contracts are manually typed into electronic processing systems after the terms are agreed upon and trades executed, mostly over the phone. Work among banks begun in 2005 to digitize the back office has led to a post-trade process that has become more electronic recently. But such automation has yet to take hold in the front office, meaning in trading, or "execution."
The main reason for the lack of electronic trading of CDS is because top derivatives banks believe displaying prices on screens will reduce the spread between the price a bank pays for buying a swap and the price this same firm can receive for selling one.
Out of the difference between the bid and offer - the spread -- a dealer pockets a portion as a fee for making or facilitating a trade. Banks also make fees for creating or custom-writing swaps that are traded later. Smaller spreads reduce the size of fees banks can take in.
That electronic or screen-based prices offered from multiple counterparties can lead to higher competition and lower, more uniform prices is consistent with predictions of standard economic theory. Empirical evidence is vast that markets with multiple sellers who compete on price transparently to buyers are fairer and more efficient with cheaper goods and higher volumes - an equation that can lead to more revenues for those "providing liquidity," meaning the banks offering such trading - versus bi-lateral, or single-bank structured markets that are typically higher in cost for bank customers but represent high-profit margins yet (arguably) lower volumes for banks.
I say "arguably" because there are no accurate nor published numbers nor even clear methods to determine which volume is higher, that of single-bank platforms or the number of trades executed over multi-bank platforms. A bank could argue its own "single-dealer" platform is the one executing more trades, as the bank's single-dealer system, while connected to the multi-bank system to operate, is the one executing the trade; the bank and counterparty just met up on the multi-bank site. So, goes this reasoning, and it's been argued to us before, "it's the bank's trade," regardless of whether the trade was "clicked" or "agreed upon" over the multi-bank system, or say, via Bloomberg. Also, the banks have argued that opening markets like bonds and derivatives to streaming, executable prices will sap liquidity. However, some critics counter, it's not the market structure that's sapping liquidity in these situations, both hypothetical and otherwise, it's the banks themselves purposefully taking liquidity away: All markets make room for methods for banks and buy-side firms to unload or sell, or buy, large amounts of securities (often referred to as "block trades") in ways meant to protect the firm from the market moving (meaning other traders trading) against their need to shed or take on a particular security or risk, if said needs are somehow discerned or broadcast to other market participants. It's easy: Firms long have just split up such orders into multiple pieces and traded anonymously. But more on those issues some other time. Anyway...
One need only basic logic to understand the fundamental principles: Screen-based markets that offer simultaneous prices from multiple providers can tighten spreads, because they bring buyers and sellers together in a single place offering multiple bids and offers that different parties can see at the same time: Price competition is more apt to occur, because when banks must vie for business simultaneously from customers they share, the prices they give, or their cost of services, become paramount to the customer's decision of with whom they'll trade. Whereas in a single-bank system, the customer must essentially trust that the bank is giving the fund a good deal, or the fund must go around separately to multiple banks to compile their prices individually and then compare these prices.
Multi-bank screen trading thus creates a more efficient as well as competitive marketplace than one which can't easily be "seen," meaning, again, one requiring a person to make multiple, sequential Web visits or phone calls to each bank, from which a list of price quotes must be, one-by-one, manually compiled and put into a chart for later comparison.
Electronic markets can boost participation and trading volumes, as more players join what's viewed as a more competitive marketplace with open, transparent, cost-effective services. As more dealers get involved, fees get squeezed further, but volumes can also grow.
However, it's important to understand that the type of screen-based trading we're talking about is predominantly request-for-quote, or "RFQ." This structure does not allow for optimal competitive and transparent pricing. Whereas stock markets do, meaning, stock exchanges offer constant streaming bids and offers, or prices - a structure considered the most open in terms of competition, where brokers are forced through the electronic publishing (the result being the public streaming like that of an electronic ticker one sees coursing the sides of buildings in Times Square, for instance, or similar, with price updates flashing almost constantly), which engenders brokers (or their computers) to compete, and nearly instantaneously, on price.
The banks participating in multi-bank-to-buy-side electronic bonds and derivatives markets do NOT even see the prices of their rival banks that are also responding to an institution's RFQ. Nor do they know the names of the other banks involved in said RFQ. The rest of the participants in the market are blind to the trade's details, except of course the buy-side institution requesting the quote. And a buy-side firm need only request one quote; there's nothing in these systems forcing buy-side firms to request pricing from more than one bank.
Said another way, RFQ, in which asset managers must request a price quote from one or several sell-side shops, is a less efficient and less competitive trading model than that of an exchange: Streaming prices are manna to the buy-side, or whomever is receiving them. The models available in the over-the-counter derivatives market do NOT involve streaming prices from multiple pricing providers (which are the banks), at the same time. It's more of a serial - or one-by-one - endeavor.
As we said in July - and in fact - there is nothing in Dodd-Frank mandating that swaps be traded over an exchange or "swap execution facility." Rather, such trading would only occur of its own accord: That is, if an exchange or swap execution facility decides to list or make available any cleared swaps for trading, then those most generic swaps that clearinghouses decide to clear, can be traded over an exchange or swap execution facility. It's a rule that isn't a rule. Cleared swaps need NOT be traded on a swap execution facility.
Read the law, a la Dodd-Frank: "With respect to transactions involving security-based swaps subject to the clearing requirement of subsection (a)(1), counterparties shall — (A) execute the transaction on an exchange; or (B) execute the transaction on a security-based swap execution facility registered under section 3D or a security-based swap execution facility that is" registered with the Commodity Futures Trading Commission.
‘‘(2) EXCEPTION.—The requirements of subparagraphs (A) and (B) of paragraph (1) shall not apply if no exchange or security-based swap execution facility makes the security-based swap available to trade or for security-based swap transactions subject to the clearing exception under subsection (g)." [Emphasis ours.]
A cleared swap need NOT be traded on a SEF or exchange. Again: There is NO RULE mandating swaps trade on a SEF or exchange.
The term "swap execution facility" is vague, but the bill basically says such a system must include multiple participants. According to the banks, that means trading with a single bank complies with the definition of "swap execution facility." The longstanding method whereby transactions are completed over the phone also fits the description of "swap execution facility," meaning any such trades need not be done electronically, or executed using only the computer screen. Given all that, there is technically no trading requirement: While it's understood that if whatever swaps any one of the platforms that registers to become a "swap execution facility" chooses to offer would become required to trade over any said facility (or exchange), whether it be that of a "single-dealer" system at one of the banks; systems of the the inter-dealer brokers, which are firms that broker CDS trades between the big banks, using mostly the phone; or platforms offered by the multi-bank-to-institutional-investors [e.g., Vanguard is an institutional investor] - the way those swaps are traded will not have to change. That's because they're still allowed to trade over the phone as the majority of swaps always have, and/or via an offering of a single bank.
Plus, the types of swaps any one of these outfits may offer will be heavily influenced by their biggest customers, the banks. Some of those banks own stakes in these systems, including multi-bank-to-institutional platforms Tradeweb and MarketAxess. Regardless, all firms offering services to banks depend on the banks for their livelihoods - the banks are the main suppliers of both their products and their profits. Therefore, they will not risk losing the banks that keep them afloat by offering anything the banks don't want them to. Plus, Tradeweb offers to buy-side firms interest rate swaps trading with single banks, as does Bloomberg. It's doubtful these platforms, or the banks that use them, would give up offering trading based on single-bank inquiries and/or pricing without first fighting to keep such capabilities. We're waiting to hear from Tradeweb on it's involvement, if any, in any such negotiations.
Our queries sent to executives listed as meeting with regulators regarding SEF definitions at J.P. Morgan and Morgan Stanley went unreturned; we asked about whether these banks separately would register their own single proprietary or "single-bank" (also referred to as "single-dealer") systems as "swap execution facilities." We know not exactly how to interpret the quiet here, so understand clearly that noting it passes no judgment. Anyway, no replies yet from these banks.
Goldman Sachs said through a spokesman that it was "premature to say" whether Goldman will register with regulators as a swap execution facility. We're in the midst of trying to follow-up with Goldman regarding MarkitSERV's interpretation of SEFs as including single-bank systems. We'll update if our follow-up query is returned. (Update: Goldman spokesman said: "We aren't going to comment on MarkitSERV's view." To which one might counter: "Isn't MarkitSERV simply the messenger here, for the banks' views?")
Anyway, according to the Dodd-Frank Act:
A “securities-based swap execution facility” means “a trading system or platform in which multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that—(A) facilitates the execution of security-based swaps between persons; and (B) is not a national securities exchange.”
The bank lawyers are arguing that Dodd-Frank seems to allow for single-bank dealing as an SEF if "multiple participants" can be viewed as being the non-bank customer participants, and multiple "bids and offers" are viewed as being those coming from a single bank sent out to different non-bank buy-side customer participants; or that the multiple prices are somehow viewed as being those of the non-bank customer participants. Others, including this banking attorney, find the argument specious. Regardless...
Also, a derivatives clearing organization can be singular too, according to Dodd-Frank:
“A person that clears 1 or more agreements, contracts, or transactions that are not required to be cleared under this Act." Said person "may register with the Commission as a derivatives clearing organization." This could be one bank then, n'est-ce pas?
Yet, despite the language in aforementioned section of the law describing a clearing firm as "a person" clearing "1 or more" contracts, the Goldman spokesman said Goldman would not register as a "derivatives clearing organization." The other banks we contacted did not respond to the question.
Definition: Clearinghouses otherwise step in between counterparties’ trades to “clear” them, or ensure each has the correct terms and enough funds so a smooth and accurate exchange of monies for securities – settlement - can occur. Doing so, clearinghouses are said to mitigate risks to the whole trading market or system involved, as well as protect the trading counterparties within the structure, by pooling and centralizing funds from all participants, monies that are aimed at backstopping the system via paying or making surviving firms whole if one (or several) of the system's major players stumbles financially and fails to meet its obligations; such a failure can threaten to financially hobble the faltering firm's counterparties too (though it doesn't follow that it always does or will), potentially (but not necessarily) triggering contagion where domino-like bankruptcies occur that could rupture the whole market. Central clearinghouses are purposed to lessen that risk; and big financial firms are required by the financial reform bill to send what looks to be their most generic, or "plain vanilla" swaps trades to these central clearinghouses.
Important: The clearinghouses (read: banks) are set to decide on which swaps will be cleared. But it's crucial to understand that there is no - I repeat - NO exchange or SEF trading requirement for any swaps: Only if an exchange or SEF decides to offer any swaps over their exchanges or SEFs, swaps which the clearinghouses (read: banks) have already decided to clear, will the mandate to trade (only these) swaps be triggered: So you see, the "trading requirement" to which much of the press, analysts and industry executives have blithely and inaccurately referred, does NOT exist: It's a rule that's not a rule.
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