Tuesday, January 19, 2010

OTC Derivatives Reform, Part 1

A few weeks ago, Mike Konczal wrote a couple of posts about OTC derivatives reform that I want to address. One was called, "An Argument for Exchanges and Swap Execution Facilities." If you haven't read Mike's post, then you should probably go read it first.

First of all, Mike claims:

I’m not saying everything needs to be forced onto an exchange proper. There are plenty of great innovations going on in the swap execution facility (SEF) world.
That's a change from the position he had taken quite publicly eight days before, when he proclaimed that a key goal of financial reform was "to get as many derivatives as possible to trade on exchanges," and told a scare story about how lobbyists (unnamed, of course) had "snuck another loophole into the OTC Derivatives bill." Mike based his story on a change in the definition of a "swap execution facility" in the final version of the House financial reform bill, which Mike claims "could, quite simply, be a telephone over which two people trade a derivative."

This is almost certainly untrue. First of all, all SEFs will have to be registered with the CFTC, which will undoubtedly prescribe conservative capital, risk management, and other requirements for SEFs, simply as a gatekeeping matter. You can't just go to the CFTC and say, "Hey, I technically meet the statutory definition of a SEF — now let me make a market in swaps!" That's not how it works. A registered SEF will have to comply not only with all CFTC regulations, but also with the 14 "core principles for swap execution facilities" detailed in the House bill. These include requirements for "timely publication of trading information" on "price, trading volume, and other trading data on swaps," as well as a requirement that the SEF maintain "complete audit trail[s]" for at least 5 years. The core principles also require the CFTC to "adopt data collection and reporting requirements for [SEFs] that are comparable to corresponding requirements for" exchanges. And the core principles are just a minimum — the CFTC can (and probably will) adopt regulations that go beyond the core principles.

So let's put an end to this meme: Under the House bill, the definition of a "swap execution facility" would not allow for a continuation of traditional unregulated OTC derivatives trading. Anyone who says otherwise doesn't know what he's talking about.

In any event, it appears that Mike is now all for SEFs, just so long as they look and act just like exchanges. Innovation! What he really wants — and what he seems to think is a magic cure-all with no negative consequences whatsoever — is pre-trade price transparency:
I want to see pre-trade price transparency. I want a facility where multiple parties can see and execute on offers from other parties. A facility that collects the prices at which multiple parties would be willing to trade a a moment in time, and update those prices as time passes.
Later, he talks up a virtuous cycle that he thinks would result from mandatory pre-trade price transparency:
The more actively traded the contracts become and the more transparent prices get, the narrower the spread. There are less economic rents, and markets becomes more efficient.
That's a nice theory, but things work much differently in reality. Pre-trade price transparency is more likely to reduce liquidity, not enhance it — especially in the much-thinner OTC derivatives markets. Let me give an example. Say a dealer makes a risk price to a client on a trade that requires the dealer to delta-hedge in size. As soon as that trade is shown on the exchange floor, everyone will know that the dealer needs to delta-hedge in size. Other traders will then front-run the dealer, moving the price away from him and benefiting from the price impact of a dealer putting on a large delta-hedge in thinner OTC derivatives markets. If the dealer knows that the mandatory pre-trade price transparency will raise the cost of his delta-hedge, then he'll simply charge the client a wider bid-ask spread. This is actually a pretty common situation, and if you think liquidity games like this don't go on all the time, then you're crazy. (This is all block trading desks did back when I was coming up.) Clients, of course, quickly realize that for even marginally complicated trades like these, they need a broker-dealer that can do the trade without moving the price much — which means doing the trade away from an exchange. (This is just one example; portfolio managers and traders can provide an endless list of comparable situations.) Once you realize that markets aren't complete, and that the majority of markets aren't nearly as deep as everyone likes to believe, the argument for mandatory pre-trade price transparency quickly breaks down.

More broadly, notice who the intended beneficiaries of all Mike's preferred requirements are: not average taxpayers, mind you, but the end-users who trade OTC derivatives. These end-users are predominantly large institutions — bond managers, institutional investors, hedge funds, large corporates, etc. If pre-trade price transparency would be so beneficial to them, then why haven't they already moved to exchanges? There's absolutely nothing stopping them — the exchanges have been offering OTC lookalikes for years, with little success. The problem is that no one wants their products. And it's not like there's no competition in this space. To the contrary, the competition among the different trade execution venues (ECNs, dark pools, etc.) is incredibly fierce.

Even the price competition in the traditional OTC market is fierce, despite what journalists think. For example, according to Risk's 2009 survey of corporate end-users, 65.3% of end-users listed price as the most important factor in choosing a derivatives dealer. Fully 73.5% of end-users negotiated with 2-3 derivatives dealers before agreeing on a trade, and an additional 14.3% of end-users negotiated with 4-5 dealers.

So what Mike is essentially saying to end-users is, "Trust me guys, even though you do this for a living, and I don't, and even though you've consistently rejected trade execution venues with pre-trade price transparency for years, I just know this is going to be better for you." Is that really how we want to legislate OTC derivatives? I didn't think so.

Much better OTC derivatives reform would require all standardized OTC derivatives to trade through regulated clearinghouses; would require the clearinghouses to publish timely and adequate trade information on price, volume, positions, etc.; and would give regulators unfettered access to clearinghouse data. Beyond that, why should we require that all trade execution venues conform to a particular model? To protect PIMCO and D.E. Shaw from the big bad dealer banks? Oh, please.


Anonymous said...

I trade for a living for a living and I think you're full of it. No demand for pre-trade transparency? ICAP's Brokertec let prime brokerage clients on their treasury repo platform after numerous customers asked for it.

Then the Banks threatened to move all their business to Liberty's TradeBlade and ICAP booted them off. Dealers have united interests and thus an oligopolistic power over the market. Don't you even realize that Pimco and DE Shaw aren't the ones clamoring for reform? The exchanges trying to pitch OTC look-a-likes get turned turned down by Pimco because Pimco's in the club! They don't want to see the system change. Its corporations they don't know jack about interest rates doing a debt offering who are getting their eyes ripped out, and their executives don't care because it never gets broken out as an explicit profit/loss. And ultimately its the share holders from these companies that lose out.

Your exchange floor example is a total strawman. First of all, regulation should be setup to protect the little guy, not the person who is going to do a trade that require the dealer to "delta hedge in size." Second, as long as the trade reporting is anonymous and the dealer is patient with the delta hedge, it takes some real balls to jump in front when you don't know what side the dealer is on.

If you want to bring up the floor, why don't you mention the fights people get in over someone stands? Or the fact that the pits used to be filled with undercover FBI agents? That should tell you that the floor was inside baseball, and right now OTC derivatives is the closest thing we've got to the floor.

Your example about getting multiple quotes is totally misleading. First off, a savvy dealer who knows the customer is going to have a pretty good guess of which way the buy is going. Second, there's no chance for the natural investor/hedger to make the bid/offer. You've got to take liquidity to get the deal done. A natural buyer and a natural seller can't trade with one another (sans a very large sunk cost in marketing, credit checking etc). The dealers of course provide a service in helping connect buyers to sellers, but more investigation needs to be done into the fact that some of the practices seem very anticompetitive.

Economics of Contempt said...

Anon @ 1:21 AM:

I appreciate your comments, and I understand that it looks different from your side of the table. But as someone who's been on the other side of the table, I have to chuckle a bit whenever I see someone refer to the dealers as "united" in anything -- over my 20+ year career on the Street, I can literally count on one hand the number of times I saw all the dealers in agreement on something. I'd liken getting all the dealers to agree on something to herding cats, but I think herding cats would be substantially easier.

I think there's something to your argument (although obviously I don't agree 100%), but it's an argument for why end-users should take their business to exchanges or SEFs with pre-trade price transparency. It's not an argument for why public policy should require exchanges and SEFs with pre-trade price transparency.

I'm not saying there's no demand for pre-trade price transparency; obviously there's some demand for it (e.g., you!). But at the same time, there are obviously a lot of end-users who don't think pre-trade price transparency is necessarily worth it (e.g., the Pimcos and DE Shaws of the world, although I just randomly chose those two), and you can't just dismiss those end-users by claiming that they're "in the club." Are those end-users' concerns somehow illegitimate or something?

It may be true that pre-trade price transparency is the best set-up for the market. But it's not at all clear that that's the case (I don't think it is the case, but Lord knows I've been wrong before). So it's difficult to justify imposing pre-trade price transparency on the OTC derivatives markets. Likewise, it's difficult to base public policy on the notion that all those corporate treasurers don't know what's good for them.

Finally, I just want to point out that my preferred solution -- clearinghouses + timely disclosure requirements -- still leaves open the possibility of a market with pre-trade price transparency. So it's not like it's anti- pre-trade price transparency or anything.

Anonymous said...

Corporates are getting their face ripped off like you wouldn't believe. I am also a trader and can confirm this.

The second group who is getting ripped off is structured note investors- your mass wealthy who end up buying capital protected notes.

The third group who should clamor for transparency is anyone who invests in corporations. Right now someone could own protection on 90% of the CDS on a given name, effectively naked shorting the company. IF you own more than 5% of a stock, you need to report this. Why should it not be any different for CDS? CDS on an exchange would clarify who owns what. Who do you think shorted Lehman out of existence? CDS holders....many of whom were CDS market makers

Anonymous said...

You must trade something a whole lot more liquid than the vast majority of OTC markets then. Since this bit of your tirade: "Second, as long as the trade reporting is anonymous and the dealer is patient with the delta hedge, it takes some real balls to jump in front when you don't know what side the dealer is on." is totally incorrect. It's incredibly easy to see what side a trade is on from the flow. How can the dealer be "patient" with the delta hedge in a moving market? And besides, if he is patient, that in turn means he needs longer to hedge, more chance that the market moves away from him, so once again, we come back to having to charge more to the end-user.

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