Sixty-two Percent of Buy-Side Firms Seek Roadmap to Navigate Emerging Regulation
State Street Corporation (NYSE: STT), one of the world’s leading providers of financial services to institutional investors, today announced the findings of a new Vision report entitled, “Charting New Territory: Buy-Side Readiness for Swaps Reforms,” exploring the readiness of institutional investors for derivatives reform. Based on TABB Group research commissioned by State Street, the report explores the readiness of buy-side swap market participants who collectively represent more than $10 trillion in assets under management. The findings illustrate the state of the industry’s readiness to implement the key provisions of swaps reform, and describe the heavy focus firms are placing on the clearing aspect of regulatory requirements while struggling to adjust to new margin demands.
Key highlights from the Vision report include:
· Margin requirements are the No. 1 focus for buy-side firms when preparing for regulatory reform
· Financial strength is the No. 1 factor when selecting a central clearing counterparty
· A drop in liquidity was cited as the most likely unintended consequence of regulatory reform
· More than one-third of buy-side firms do not have the high-grade collateral required to enable swaps trading in a centrally cleared world
· Reporting is the regulatory component for which buy-side firms feel least prepared
The report also explores the key issues the buy-side must solve to successfully transition to the post Dodd- Frank environment including:
· Overall buy-side readiness for derivatives reform in various categories including registration, capital/business standards, trading technology, selection of futures clearing merchant (FCM) or swap execution facility (SEF) and organized trading facility (OTF), and reporting
· Key concerns for the buy-side with respect to the pending changes
· The services and other factors that could influence decisions to choose an FCM, SEF, and central clearing counterparty (CCP)
· Potential unintended consequences of regulatory reform
“The buy-side supports the idea of transparent markets and the entry of new participants to compete in a market place traditionally dominated by a few key players, and generally sees the regulations as fair and benign, but also as more costly,” said Clifford Lewis, executive vice president and head of State Street’s eExchange business. “However, the process of transformation is challenging and it dominates the buy-side’s thinking. They see a long road ahead before there will be collateral-efficient clearing solutions, competitive electronic execution and increased volumes that mitigate concerns about liquidity.”
Readiness
Across the five aspects of readiness for OTC reform, including registration, capital/business standards, trading technology, selection of FCM/SEF and reporting, not one buy-side firm stated that they were fully ready in any of these categories. For firms who anticipate being regulated as swap dealers/major swap participants, reporting requirements are the area in which they feel least prepared.
· Most survey participants don’t plan to begin clearing until the regulations are adopted, with 52 percent saying a target date would drive them to clear sooner and 45 percent citing credit concerns as a reason for clearing early
· Eighty-one percent of the firms we spoke with intend to continue trading uncleared products
FCM Selection Factors
For firms looking to choose an FCM, the most important decision driver is the capability to onboard clients and backload existing trades, followed in importance by collateral / margin services. The study indicates that the selection of CCPs is driven primarily by its relative financial strength, identified by 58 percent of buy-side firms as of “high” importance when selecting at CCP, followed by margin requirements and netting efficiencies.
“It is fair to say that the current buy-side focus on clearing now has eclipsed their focus on trading and connection to SEFs/OTFs at this stage,” said Will Rhode, principal, director of Fixed Income Research at TABB Group. “Execution is the thinner end of the wedge when it comes to regulatory reform and the buy- side is having trouble digesting the margin demands being placed upon them. There are also major question marks over whether the bundling of clearing with discounted execution services will be allowed under Dodd-Frank, which stipulates that dealers cannot incentivize firms to clear with them by offering trading discounts.”
Unintended Consequences
As regulatory extraterritoriality, or the way in which varying regulations in different jurisdictions overlap, collides and goes live at different times, the complexities of developing a compliance framework could regionalize what has been a global marketplace. The majority of respondents believe that the migration of bilateral OTC markets into a central clearing counterparty paradigm will drive margin and collateral costs significantly higher, which will in turn influence product selection and render some exotic trade structures extinct. Fifty-two percent of study respondents believe liquidity will dip when the regulations are adopted, 38 percent think a collateral shortage will result and 31 percent foresee an increase in trade and pricing errors.
· As margin calculations move from overnight to intraday, the need for “collateral velocity” to enable trading will increase
· The forced migration of execution from phone to electronic via SEFs/OTFs could dramatically enhance volumes in vanilla swap-products and usher in a radically different trading model, but multiple SEFs/OTFs, trade repositories and other systems will drive a need for much greater connectivity and infrastructure
· Reporting requirements will add another layer of complexity to the market
· Regulations will provide more transparency into costs throughout the entire derivatives lifecycle – with explicit price tags attached to each element
“The results of this survey clarify that the focus for buy-side firms should be on the entire derivatives lifecycle, not just clearing,” said Jeff Conway, executive vice president and head of Investment Manager Services at State Street. “Concerns over a decline in liquidity, collateral shortage or increased trade and pricing errors as a result of the implementation of these regulations are front of mind; however, the firms we surveyed vary widely in their readiness to fully implement the changes required and in their timeline for becoming compliant. The changes to market structure are so multi-dimensional and complex that firms are taking longer than anticipated to prepare.”
