OTC derivatives - have SEF regulations helped liquidity? Quite the opposite, says commissioner Giancarlo.
The SEF trading mandate along with considerable technology implementation is now here but still less only 50% of US OTC trading is on SEF (up from 10%). As with corporate bonds covered below, dealers are trying to move towards risk-less principal or agency trading models piggybacking on the SEFs. Even the 50% flatters to deceive as this includes voice-enabled trades reported through the SEF platform.
In his conference keynote speech, CFTC commissioner J. Christopher Giancarlo did not mince words in calling for a revamp of the CFTC SEF rules which he believes miss the legislative intent of congress in Dodd-Frank and crimp liquidity by restricting trading methods and fragmenting liquidity pools and cross-border trading. An executive summary and full white paper are on the TABB website here
and there is a risk article on the speech here
- It will be interesting to see whether Chairman Massad takes up Commissioner Giancarlo's suggestions.
Corporate bond trading liquidity - a work in progress
A big focus of the conference sessions and sponsors was corporate bonds. QE and the resulting investor search for yield has led to a glut of corporate issuance at the same time as market-maker bank balance sheet withdrawal due to Basel III pressure - heightening focus on corporate bonds liquidity in the secondary market.
- Smaller buy side firms may struggle in corporate bond trading especially in high-yield unless on a buy and hold strategy.
- Now is the time for all-to-all and dealer agency trading to establish market share but they are not panaceas, not all institutions will use them and not all bonds will be liquid enough.
- Perhaps some bonds drop out of secondary trading and become "buy-at-issue-hold-to-maturity"?
Regulatory Context: you might be hoping that market-making regulatory impacts are over with? Afraid not.
1. Basel III risk-based and leverage ratios - are live but the risk-based capital ratios ratchet up through 2018 from 8% to 10.5% due to the "conservation buffer" and there could be further surcharges for largest banks.
2. Basel III liquidity coverage ratio (LCR) (daily from July 2015) - banks can't easily term fund transient market making inventory in less liquid securities / corporates beyond 30 days so they'll incur LCR denominator usage.
3. Volcker rule (July 2015) - in theory dealers are allowed to hold positions commensurate with client demand. In practice this can only further constrain market making inventory.
4. OTC bilateral margin mandate (Dec 2015) - mandates IM and associated funding costs and leverage ratio impact on buy side trades and the associated dealer hedges.
5. OTC client clearing (US live, EU 2016) - this may lead to a capital strain on banks FCMs / clearing brokers as the quantum of aggregate client risk and the client default fund subsidy by FCMs increases.
6. U.S. Intermediate Holding Company (IHC) (2016) - grosses up capital costs by region for EU and Japanese banks.
- For corporates, beyond Basel III capital, the main effects are Basel III LCR, Volcker and US IHC.
- All of the above affect OTC derivatives. Beyond electronic trading, netting and compression vendors may help free up capital usage. Trade compression was the story of 2014 with TriReduce's ramp up and LCH and CME starting trade compression services. LCH was represented on a panel at the conference. Looking forward startups like LMRKTS and NetOTC (see risk article) may have a part to play in reducing risk / RWAs / funding costs rather than just notional / leverage ratio exposure.