Swap market liquidity has most definitely fragmented since the onset of new regulations, and that liquidity is often a challenge to access for many small and mid-size companies, but in the big picture instituting clearing and various other requirements impacting the swap market has improved liquidity.
The Commodity Futures Trading Commission’s (CFTC) Market Risk Advisory Committee reached those general conclusions at a recent meeting discussing the increased concentration of futures commission merchants (FCMs) and other factors impact market liquidity.
Piers Murray, managing director at Deutsche Bank, noted there were more than 200 FCMs–brokers in the swap and exchange-traded futures markets–and today that number is less than 100. In addition, the concentration of FCMs is greater still in the over-the-counter swap (OTC) market.
“Each absence of [an FCM] will generate more stress and risk to the remaining community,” Murray said.
CFTC Chairman Timothy Massad provided some relief by noting many of the FCMs that have disappeared didn’t hold customer money and traded for their own accounts, and that the decline of those that did hold customer money was significantly less. In addition, the said, the concentration of customer money among the top 20 FCMS, about 91% of the total, has remained about the same, although the top 10 FCMS now hold a greater portion than before.
The consensus among Advisory Committee participants was that several factors have led to fewer FCMs, with new regulations playing a significant role. Luke Zubrod, director of risk and regulatory advisory at Chatham Financial, noted during the session that new regulations stemming from the Dodd-Frank Act as well as the Basel Committee have escalated costs for intermediaries and their clients, resulting in a less dynamic market.
“Whereas bank marketers often used to tout their banks’ ability to deliver efficient pricing on a trade, now conversations with traders are more about why they can’t deliver efficient pricing,” Mr. Zubrod said.
He added that it’s relatively easy for large corporates with established trading lines to transact, but smaller and midsize corporates seeking to establish bank relationships face challenges, as banks weigh the merits of going through the regulatory process. Mr. Zubrod noted a recent conversation with a banker who said his institution is no longer bidding on caps and other options when the bank isn’t the lender on the underlying loan, because it can’t justify the associated internal compliance costs.
“The banker said he would let us know if this changes, but for the time being the bank will be passing on any such deals we show them,” Mr. Zubrod said.
Rana Yared, a managing director at Goldman Sachs, emphasized that liquidity varies among different markets. For example, some corners of the credit default swap market have seen liquidity increase over the last year, while interest-rate swaps present a “true potential for a liquidity crunch,” given challenges executing transactions well under $500,000 in size—not especially large blocks. She noted new capital rules under Basel II has one factor, resulting higher capital costs for cleared trades, a regulatory outcome that seemingly contradict regulators’ desire for more cleared transactions.
One likely consequence, she added, is that a significant amount of hedging simply isn’t getting done, and another is a bifurcation in pricing between cleared and uncleared liquidity, a trend that could exacerbate liquidity challenges.
Many concerns among participants centered around more burdensome capital requirements, over which the CFTC has no authority. However some suggestions to improve liquidity that the CFTC could potentially affect emerged throughout the session, such compiling more data with which market participants could more effectively measure liquidity, and creating incentives to draw wider variety of market participants.
In the bigger picture, said several participants, the derivative market today is going through major changes that, while challenging, represent an improvement in terms of liquidity compared to before the financial crisis.
“Pre-central clearing, before the financial crisis, every trade with every counterparty was bespoke [and illiquid] instrument,” said Isaac Chang, global head of fixed-income as KCG, a major market maker across a broad range of financial products, “So I think we’ve moved a long and very positive way since then.”