Global derivatives markets are continuing to fragment along geographic lines as a result of divergent regulations across jurisdictions, according to new research published today at ISDA’s 30th Annual General Meeting in Montreal.
The research shows an average 94.3% of regional European interdealer volume in euro interest rate swaps (IRS) was traded between European dealers between July and October 2014. The share of the exclusive European dealer pool fell slightly to 84.5% in December 2014, reflecting a general decline in euro IRS trading activity between European institutions in the fourth quarter of last year.
In comparison, the exclusive European dealer pool for euro IRS averaged 73.4% in the third quarter of 2013.
The change coincides with the introduction of US swap execution facility (SEF) rules in October 2013, which required electronic trading venues that provide access to US persons to register with the US Commodity Futures Trading Commission (CFTC) and comply with SEF rules. The proportion of euro IRS trades conducted between European dealers rose 20 percentage points between September and October 2013 to reach 90.7% in October 2013, suggesting non-US participants started to avoid trading with US dealers where possible to avoid being subject to US SEF rules. Just 2.9% of euro IRS trades were between a European and US dealer in August 2014, compared with 28.7% in September 2013.
“ISDA’s research demonstrates that the fragmentation of global liquidity pools continues to be a problem. Fragmentation means less liquidity, less choice and, ultimately, higher costs for end users,” said Scott O’Malia, ISDA’s Chief Executive Officer. “It’s important that regulators coordinate and cooperate to eliminate inconsistencies in their rules and ensure derivatives end users can tap into deeper liquidity pools.”
Although regional pools exist in the market for US dollar IRS, evidence of fragmentation is more subtle than in the euro IRS market. US dollar IRS trading between European and US dealers in the European regional interdealer pool reached a low of 35.9% following the introduction of the SEF rules in October 2013. Since then, the cross-border pool has steadily increased and surpassed the exclusive European pool in September 2014. This could reflect the fact that the US dollar IRS market is US-centric and is primarily traded on SEFs.
ISDA recently published a set of principles for the centralized execution of derivatives, aimed at encouraging regulatory consistency of centralized trading rules, and facilitating equivalence and substituted compliance determinations.ISDA believes certain regulatory changes need to be made to the US SEF rules in order to comply with the ISDA principles and to achieve a harmonized international regulatory regime. The necessary regulatory adjustments would include changing the process for making mandatory trade execution determinations to ensure it is based on objective criteria and supported by data, and to allow greater flexibility in swap execution mechanisms.
Summary of the ISDA fragmentation analysis:
• The cleared euro IRS market remains largely fragmented in US and non-US liquidity pools. This split was first observed in October 2013 after the CFTC’s SEF regime came into force.
• More euro IRS volume is now transacted exclusively between European counterparties than before October 2013. During the fourth quarter of 2014, an average of $2,221 billion per month of euro IRS, or 87.7% of total euro IRS volume by notional, was transacted exclusively between European dealers. During the third quarter of 2013 (prior to the start of the SEF regime), an average of $1,708 billion per month of euro IRS, or 73.4% of total euro IRS volume by notional, was transacted exclusively between European counterparties.
• The notional volume of the European-to-US interdealer cross-border euro IRS market has decreased. During the fourth quarter of 2014, an average of $264 billion per month of euro IRS, or 10.8% of total euro IRS volume by notional, was transacted between European and US counterparties. During the third quarter of 2013, an average of $598 billion per month of euro IRS, or 25.8% of total euro IRS volume by notional, was transacted between European and US counterparties.
• The percentage of euro IRS trades exclusively between European counterparties in the fourth quarter of 2014 was modestly lower than in previous quarters. Conversely, the percentage of trades between European and US counterparties was slightly higher. The change reflects a decline in underlying activity in euro IRS between European institutions over the period. Fourth quarter average notional volume fell 8.3% versus compared with the same period in 2013. A 25.3% decline in volume occurred between November 2013 and November 2014 alone.
• European-to-US cross-border market share for US dollar IRS has now surpassed exclusive European and US dealer volumes. Continued growth of the cross-border pool will rely on the harmonization of rules in various regions, as well as participation on SEFs.
• Total global liquidity of cleared US dollar IRS volume increased 7.8% year-on-year, from $2,035 billion in 2013 to $2,194 billion in 2014.
A full version of the analysis can be found on the ‘Research’ section of ISDA’s website under ‘Research Notes’.
