As the price tag gets bigger for executed and cleared over-the-counter (OTC) derivatives trading, many firms are thinking about sidestepping the swaps markets to come and putting more effort into futures markets. This scenario is emerging as firms review their strategies for post-Dodd Frank OTC markets and find too many complications such as a severe lack of collateral.
Some of what State Street uncovered and presented earlier this week is not necessarily new. For instance, the sell side is way ahead of the buy side when it comes to being ready for the OTC trading overhaul. Not a single buy-side firm surveyed is “fully ready” in any of the five key aspects of executed and cleared OTC trading identified by State Street: registration, capital/business standards, trading technology, the selection of an FCM or swap execution facility (SEF), and reporting.
This prompted Charley Cooper, senior managing director of State Street Global Markets, to urge the buy side to play a more active role and use the “market power” it has to influence the process. Otherwise, it will be a missed opportunity.
As for the shift toward futures, JR Lowry, senior vice president of State Street Global Services, says that the choice would be a trade-off between “an imperfect hedge and something more precise” such as a swaps transaction, which came about in part because of dissatisfaction with futures trading. Yet Lowry says that there could be a shift because of the forthcoming high margin requirements.
“Our guess is that it’s temporary,” said Cooper, who speculated that as the post-Dodd Frank OTC market matures, costs will stabilize and so will the search for collateral. Overall, pricing models will take at least a year to shake out, and clearing and execution services are likely to remain tightly bundled, added Will Rhode, director of fixed income research at Tabb. Along those lines, Cooper said customers are just beginning to ask for pricing breaks on custody services if they also use State Street for clearing.
However, an unusual and more troubling contradiction was unearthed by the survey.
While the high price-tag and “collateral scarcity” are growing concerns in the US and Europe, a majority of firms surveyed—81 percent—said they will continue to trade in “uncleared products.” The regulators have yet to finalize the sticker price for post-Dodd Frank bilateral transactions but it’s certain to be much higher than cleared and executed trades.
So, another read on the State Street survey results is that there may a meaning to the madness of doing nothing. It could be that buy-side firms are biding their time as the sell side rushes to the brave new world of OTC trading. When push comes to shove, the buy side will retreat to the futures markets (or other markets) to temporarily ride out the storm. They will dabble in extremely expensive bilateral OTC trades now and again when it suits them.
I’m not sure that’s a prudent strategy but it looks as if that’s what a sizable number of buy-side firms are contemplating. The burning question then becomes—if they bypass the first years of the new world of OTC trading, will they ever want or be able to join it later?