when waves of structured finance downgrades

marked the start of the crisis, securitised products have been battling stiff headwinds – many of them regulatory. So-called ‘skin in the game’ rules now force issuers to retain risk in new deals, capital requirements for banks and insurers are being cranked up, and regulators are closely scrutinising new transactions for signs of capital arbitrage.

Recently though, some supervisors have been singing from a different hymn sheet. Most significantly, the final text of the fourth Capital Requirements Directive (CRD IV), agreed by the Council of the European Union (EU) on May 15, opens the door for residen-tial mortgage-backed securities (RMBSs) to count towards banks’ stocks of liquid assets.

“There’s a lot of schizophrenia right now. On the one hand, policy-makers are commenting on the benefits of securitisation, but on the other hand, they’re penalising it,” says one London-based securitisation head at a major European bank.

The change in tone is because Europe’s banks are under pressure. The European Banking Authority (EBA) expects the industry to achieve a minimum 9% Tier I capital ratio by the end of June, at a time when banks also have reduced access to traditional financing markets. Putting it simply, the response has been to sell assets and constrain loan growth.

During a speech in New York on April 11, EBA chairman Andrea Enria acknowledged the pressure. Some de-leveraging was neces-sary, he said – and supervisors should work with banks to ensure risky exposures were wound down and losses recognised. At the same time, he also urged regulators to “work with banks to identify pathways to new and diverse sources of funding”, with less reliance on short-term wholesale funding.

“This rebalancing in the funding models is a necessary component of a process that will lead banks to gradually exit from the extraordinary support measures provided by their central banks. An important compo-nent of this strategy could be supporting industry initiatives to re-establish a sound and well-controlled market for securitisa-tion,” he said.

Bankers and analysts welcome the change of heart, but warn a large-scale revival of the European securitisation market will not be easy – and one of the biggest obstacles standing in the way continues to be regula-tion.

“For the securitisation market to play a material role in funding the real economy in Europe, the market needs to be materially larger than its current size. Most investors are quite happy with the product, but there are many regulations coming down the line, such as Solvency II and Basel III, which are combining to create a disincentive for investors to buy securitised paper and pushing them to buy other products instead,” says Robert Plehn, London-based head of asset-backed solutions at Lloyds Banking Group.

CRD IV could change that. If RMBSs or other asset-backed securities (ABSs) can be counted towards the new liquidity coverage ratio (LCR), bankers say it would give the market a much-needed boost – but while the door is currently open, it could be slammed shut. “There’s a big question over whether and how ABSs will be treated in the Basel III LCR as implemented in Europe through CRD IV. To date, there is concern that it won’t be included in liquidity calculations at all,” says Kevin Ingram, a London-based partner at law firm Clifford Chance. The LCR requires banks to have enough liquid assets to survive a one-month period of

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1 Risk25 August 20121 Risk25 July 2012

It sometimes feels like everyone wants to be a swap execution facility (Sef). The problem is that no one knows for sure what the precise requirements will be. The Commodity Futures Trading Commission published its proposals in January 2011 but, at the time of press, final rules had not been agreed. A similar situation exists in Europe, where regulators have yet to confirm their rules on organised trading facilities (OTFs). This puts would-be Sefs and OTFs in a difficult situation – firms need to get the development work done, but don’t want to build something that does not conform to the final regulations.

This hasn’t stopped firms announcing their plans to register as Sefs and OTFs. At least 15 firms are likely to launch Sef offerings,

including the established interdealer brokers, existing multi-dealer trading venues and new start-ups. The approaches they are taking differ quite significantly. Some are based on a central limit order book (Clob), while others use request-for-quote (RFQ). Some focus on specific asset classes, while others offer multi-asset-class functionality. The one thing they all have in common is the need to attract liquidity. Few participants think every one of the current batch of would-be Sefs is viable. Some may not make it off the launchpad, while others will need to quickly attract business or fold. Either way, the winners and losers in this new market should be decided fairly quickly.

Sefs/OTFs

TradewebNew York-based Tradeweb has been a pioneer of electronic execution since launching its first US Treasury trading platform in 1997, but the breadth of its product offering – which ranges from interest rate and CDSs to US Treasury bonds to repos – distinguishes it from many of its likely competitors. Minority-owned by a group of banks, some rivals have complained these dealers will have an incentive to route liquidity through the platform and potentially provide preferential prices. Assuming regulators don’t take issue with the ownership structure, Tradeweb is likely to be one of the Sef success stories.

With over-the-counter derivatives markets in flux, picking winners and losers is a tough job. This is where Risk’s editorial team nails its colours to the mast. By Lukas Becker, Matt Cameron, Laurie Carver, Clive Davidson, Ramya Jaidev, Peter Madigan, Mark Pengelly, Joe Rennison, Nick Sawyer, Michael Watt and Duncan Wood

Anyone who wants to understand how OTC derivatives markets are changing should keep an eye on the 74 organisations named as our Firms of the Future. These are the dealers, buy-side firms, brokers, exchanges, technology vendors, clearing houses, regulators, infrastructure providers and trading platforms we believe will be most influential over the next five years.

Compiling this kind of list is tricky at the best of times, but when the OTC market – plus prudential regulation and the banking industry more generally – is changing so dramatically, it becomes even harder. We will undoubtedly get things wrong. Some of the names on the list may fade from view by the time Risk celebrates its 30th anniversary, and names we have ignored will surge to prominence.

Two or three years ago, some of these organisations would not have featured – without new trading, clearing and reporting rules, estab-lished companies like BNY Mellon, State Street and the Depository Trust & Clearing Corporation (DTCC) had no obvious role to play in the OTC market. As evidence, look at Citadel and CME Group, which

had been knocking on the door for years – they too will now have a say. Other names did not exist at all – Eris Exchange, New York Portfolio Clearing (NYPC) and Regis-TR, for example.

The fortunes of many of the listed firms are bound tightly to the market’s new rules, which is why we include the regulators as well. One example is TriOptima’s new service, triBalance, which has dealers queueing up to praise it, but requires a regulatory safe harbour to work. It may simply be too late in the day for that to be forthcoming. Another instance is Project Trinity, the clearing initiative being explored by LCH.Clearnet, the DTCC and NYPC. It is concep-tually elegant, but requires a way of calculating margin offsets across three types of asset at three different clearing venues. That requires careful regulatory scrutiny but if it can be made to work, it could be a genuine alternative to the vertical business models at CME Group and Eurex.

With lots of twists and turns to come, it should be an interesting period – and we’re happy to be reminded of our choices in 2017.

clearing, reporting – of the three strands of over-

the-counter derivatives reform agreed by the Group of 20 (G-20) nations in 2009, dealers could probably have lived with the last two. The market had already been moving towards wider use of central counterparties – although admittedly, just for interdealer trades – and regulatory reporting will not fundamentally affect the economics of the business.

Rules about how and where OTC products are traded are a different mat-ter. They threaten to kill off single-dealer platforms and voice trading, allow clients to trade with each other or with new classes of liquidity provider and introduce cen-tral limit order books to OTC markets, which will result in reduced margins and more standardised products. Put simply, of the G-20 reforms, execution rules are the biggest threat to the profitability of OTC market-making (Risk May 2011, pages 60–62, www.risk.net/2044721).

Lee Olesky, Tradeweb’s New York-based chief executive, has a take on this topic that dealers will find reassuring. He is scepti-cal that order books will be the dominant mode of trading in OTC markets and that trades will be habitually executed between non-dealers.

“If the world of OTC products narrowed significantly and traded on an exchange, no dealer would have to act as a price-maker. But that is simply not how fixed-income markets operate, let alone the derivatives markets. The constant underwriting and dis-tribution that underpins both bond issuance and the pricing of derivatives contracts will probably prevent most current swap classes from trading in an order book in the fashion of equity markets,” says Olesky.

The obvious retort to this line of argu-ment is that a dealer-supported platform

would naturally take this position. Tradeweb was founded by a consortium of banks in 1997 and, although a majority stake was sold to Thomson Reuters in 2004, it is still part-owned by 10 dealers. The request-for-quote (RFQ) model it uses for OTC trading mimics the market’s practice of agreeing trades over the phone: a user of the platform specifies the trade it wants to execute and invites one or more banks to provide a price. As such, if dealers could pick a winner from the crop of new trading venues, many would choose Tradeweb.

But that doesn’t make Olesky’s predic-tions incorrect. Since Tradeweb launched its derivatives trading service for interest rate swaps and credit default swap indexes in 2005 – later extended to include European equity derivatives and foreign exchange options – over 340 buy-side institutions have executed more than 115,000 trades with a notional value of more than $11 trillion on the platform. By May 2012, the average daily volume in all derivatives traded on the plat-form stood at $7.5 billion, so Olesky should know what he is talking about.

More importantly, while Tradeweb is known as an RFQ platform – and a friend of the dealers – Olesky’s doubt about order books is not as definitive as it might sound.

“RFQ is where our derivatives business is currently focused, but we need to be pre-pared for the evolution in the market over the next five years. How electronic trading will evolve in the future will depend on whether the market stays the way it is. If the swap trading model changes from one in which dealers extend liquidity to custom-ers, and we see the increasing participation of hedge funds and high-frequency traders and other participants in swap markets, then I think we will see greater develop-ment of order books, along with RFQ or streaming prices to cater to the needs of

SEFS/OTFS

Execution,

Tradeweb

“The constant underwriting and distribution that underpins both bond issuance and the pricing of derivatives contracts will probably prevent most current swap classes from trading in an order book in the fashion of equity markets” Lee Olesky, Tradeweb

risk.net/risk-magazine 2

these different users,” Olesky says.So, will derivatives markets become

less dealer-centric? That depends, to a large extent, on how final rules are writ-ten in the US and Europe. The Com-modity Futures Trading Commission (CFTC) published its proposals on swap execution facilities (Sefs) – the name given by the Dodd-Frank Act to the new venues on which standardised OTC derivatives should be transacted – at the start of 2011. Arguably, the key phrase was the requirement that a Sef should be a venue “in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants”.

The CFTC interpreted that to preclude single-dealer platforms and voice-brokered swap trades from meeting the multiple-to-multiple principle of the act. But, more broadly, the provision has led to widespread market speculation that the regulator hopes to encourage non-dealers to transact swaps directly with

one another, disintermediating the small group of banks that has dominated the market since its birth.

On an order book platform, two buy-side firms could take each other’s bid and offer anonymously, cutting dealers out of the transaction. Olesky is not waiting for that to happen, but he is also not ruling it out.

“The multiple-to-multiple issue will come down to the business objectives of the entity in question. Are they in the swap market to hedge a position, to manage a portfolio, to seek return as an asset manager or as a dealer to earn money by making markets?” asks Olesky. “Historically, there have been price-makers and price-takers. Today, the fact is you are getting prices quoted by a variety of liquidity providers, with the buy side surveying those prices. If you have two traditional buy-side firms, the big question is, will one of them want to get into the business of quot-ing prices?”

Commodities – a special caseAlthough Tradeweb’s existing OTC business has expanded from its roots in fixed income and credit to cover forex and equities, the company will not move into commodities, says Olesky. He expects the Sef universe to be divided along the same lines: one subset of venues will provide execution in a range of financial derivatives, while a second group will specialise in energy and commodity derivatives.

“I think we are going to see the evolu-tion of trading venues that will try to cap-ture a number of asset classes. Tradeweb, for example, trades interest rates and credit derivatives, as well as forex and equity derivatives. That is the swap universe we are focusing on, and there is only going to be a limited number of Sefs that will be successful in that universe,” he says.

“It’s a different story in energy and com-modity derivatives. We are not in that area right now, and I think that space might be populated by a completely separate group

of Sef operators. Ultimately, I don’t think there will be more than three or four Sefs that trade every asset class and, if that does happen, it would be a very long way off because there is a synergy across all swap products to make such a universal trading venue feasible,” he adds.

With the exception of commodities, Olesky argues Sef operators will try to be all things to all people – a result of the costs involved in building a plat-form. The check list of requirements includes a matching engine, connectiv-ity to buy-side institutions, clearing houses and trade repositories, the ability to receive, sort and display prices from liquidity providers, and credit-checking systems (Risk May 2012, page 32–37, www.risk.net/2169606).

“The costs associated with technology are likely to drive Sef operators to try to leverage their platforms to offer as many products as they can. Just as there is a small group of large exchanges around the world that seems to be shrinking over

time, that same dynamic will develop in the Sef universe,” says Olesky.

“If you are spending a lot of money on technology, there will be huge benefits to be reaped in offering as many products as can be supported by that framework. If you are supporting multiple markets, you can drive your per-unit cost down, and that means you can be more aggressive in your pricing and attract more clients.”

For the same reason, Olesky is scepti-cal about the prospects for aggregation services that allow clients to access swap prices from a number of Sefs via a single interface (Risk June 2011, pages 18–22, www.risk.net/2073226). If the market is dominated by a handful of platforms, each offering a way to trade the main derivatives asset classes, and is backed by the same dealers that are quoting the same prices, there should be no need for a separate entry point, he argues.

“The only reason you would need to aggregate is because you cannot get a complete picture of the market. A client would only need to pull many different platforms together if it is getting a dif-ferent price here or a different group of participants there. If Tradeweb already has a critical mass of participants on its platform, then there should be no need for aggregation. My point is that I don’t think dealers are quoting different prices at different venues, so the Sefs themselves will act as price aggregators.”

That makes sense if Olesky’s expecta-tions prove to be correct. A lot hangs on how many platforms launch, how many asset classes each covers, whether all venues are backed by the same liquidity providers and how long it takes for the market to consolidate.

Olesky thinks most of the volume will end up being funnelled through a relatively small number of venues. He declines to predict winners and losers, but identifies what he sees as the deciding factors.

“There is a cost associated with being active in a bunch of different markets, so I think users will choose a handful of Sefs to connect to – maybe three to five platforms. As for the identity of those platforms, the incumbent platforms with well-established technology that the market already has confidence in, with well-networked businesses that already have a large community of participants, and with a certain amount of market expertise among their staff, would certainly have an advantage,” he says. ■

“We are going to see the evolution of trading venues that will try to capture a number of asset classes. Tradeweb, for example, trades interest rates and credit derivatives, as well as forex and equity derivatives” Lee Olesky, Tradeweb

SEFS/OTFS

3 Risk25 July 2012

THIS IS DERIVATIVES TRADING NOW.INTEREST RATE / CREDIT / EQUITY / FX

The world of derivatives trading has changed forever. At Tradeweb, we’re spearheading the

movement towards more liquid, transparent, and effi cient markets that regulators require.

For more than a decade, we’ve been relentlessly setting new standards for the trading of fi xed

income and derivatives. That’s why the leading institutional investors depend on our markets.

derivatives.tradeweb.com

© 2012 Tradeweb Markets LLC. All rights reserved.Tradeweb provides fi xed income and derivatives markets for Institutional Investors.

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