The SDMA ushers in open OTC clearing in a bid to prevent future fiascos

The rise of the Swaps and Derivatives Market Association (SDMA) is the story of many Davids taking on several Goliaths over a powerful idea—democratizing clearing for over-the-counter (OTC) derivatives such as credit default and interest rate swaps. In its first year, the SDMA has garnered more than 20 public and private members, engaged powerful Congressional leaders who steered the Dodd-Frank Act, challenged entrenched players, and played a key role in a sweeping change for a restricted market.The SDMA was born during the credit crisis after the downturn in 2008, according to Jamie Cawley, CEO of Javelin Capital Markets and Mike Hisler, Senior MD—CDS for Javelin, the co-founders of the SDMA.

Early last year, approximately 25 independent clearing brokers and dealers reacting to the government mandate for the clearing of OTC derivatives gathered at the Harvard Club of New York City. The meeting led to the quick birth of the SDMA in January 2010; its membership now includes broker/dealers, futures commission merchants and investment managers.

 

“The genesis of the SDMA came about because of the lack of a unified voice that supported effective reform of the OTC derivatives markets when speaking with legislators and regulators,” Cawley says. The decision to work with the government is an acknowledgment that the industry failed to regulate itself when it came to derivatives.

To be clear, Cawley does not view the deep recession of 2008-09 as a Black Swan event. In his view, it’s more like a replay of the Long Term Capital Management debacle.

“We do need regulation to work with industry to make sure it doesn’t happen again,” says Cawley. He adds that the SDMA has the ear of legislators in Washington, particularly the Senate Banking committee. “The alternative is that we ban derivatives.”

New regulations rather than a ban are on the way for the now-private, bilateral derivatives markets for CDS and IRS instruments (please see chart). The new rules are slated to revamp current clearinghouse practices such as steep net worth capital requirements that range from $500 million to $5 billion, according to Bloomberg News reports. They also have transaction stipulations, effectively restricting access to OTC clearing services to about 20 A-List, global firms that are household names.

New Rules for OTC Clearing

Dodd-Frank is spurring new rules for OTC clearing that are being written by the CFTC and the SEC. In short, swap dealers and major swap participants transacting CDS and IRS instruments must meet standards for central clearing. They will also have to use exchanges or new venues to be known as swap-execution facilities (SEFs). While much is yet to be decided, central clearing for OTC derivatives will likely result in:

• New links among SEFs, clearing platforms and swap data repositories
• New back-office operations to capture and calculate risk for margining
• Execution facilities that provide timely information on price, trading volume and other transaction data
• Execution facilities that conduct surveillance and monitoring of credit derivatives
• All swap market participants keeping daily transaction records and supporting data for audit trails

“We think that having clearinghouses with five or six large, correlated clearing brokers feeding in and managing that risk is ineffective and dangerous,” Cawley says. The incumbent dealers, however, see the SDMA’s efforts and pending regulations as threats to “the revenue that they have historically taken from the OTC derivatives marketplace” for 20 years, he says.

“The fact remains that the same systemic risk sits in the system today as was in the system in 2008. We’re still dangerously exposed,” Cawley says.

The Dodd-Frank Act, signed into law this past July, is intended to head off that exposure by replacing the bilateral environment with open access to OTC clearing for independent broker/dealers and clearing firms.

Clearing reduces the need for firms to use their balance sheet in “some of these transactions and therefore you could have more participating brokers,” says Stephen Bruel, research director, securities and capital markets at TowerGroup, based in Needham, Mass. “And, therefore, you’ll have more competition for pricing and spreads.”

But the goals of regulators go beyond clearing. They want more competition “in terms of the pricing, the transparency and the offerings so that it becomes a more level playing field and you don’t concentrate so much activity with the large dealers,” Bruel says. “The SDMA is pushing to democratize the field by eliminating the balance sheet requirement from the OTC derivatives clearing world.”

The SDMA has “had an amazing influence for an organization of its youth,” says Gary DeWaal, senior managing director and group general counsel for brokerage Newedge Group, an SDMA member. Newedge joined SDMA because it agrees that OTC marketplaces should no longer be restricted to a few players.

“Clearing doesn’t work well when it’s limited to a few clearing members,” DeWaal says. “We support additional players entering the OTC space, particularly in the cleared space—both on the buy side and the sell side.” The SDMA is taking steps to ease access to the buy side, which makes life easier for Newedge’s customers. “We also like to go where our clients and potential clients are.”

Newedge Group provides asset execution, asset clearing, prime brokerage, and assets financing services for cash markets and OTC derivatives in fixed income, foreign exchange, equities and indexes, and commodities including agriculturals and softs, energy and emissions and metals. Société Générale and Crédit Agricole CIB established Newedge as a 50/50 joint venture that combines the resources of Calyon Financial and Fimat.

Yet while buy-side firms may like the reforms to come they have reservations about the market structure supporting open OTC clearing, the new IT requirements and the new cost structures to come. The buy side “loves the idea of clearing and reducing counterparty risk, but they do not like the current mechanism by which they trade and they’re not prepared for it yet,” Bruel says. “We’re in a situation where the overall thesis behind the regulatory changes is positive but we’re going to actually have implementation issues.”

The buy side is focusing on “the key question of how clearing affects the economics of trading over the counter,” Bruel says. “That extends to what your clearing broker charges you, the margin required by the CCP (central counterparty clearinghouse), and the type of collateral that you need to pledge to the CCPs.” Firms will have to add in other variables that will affect the pricing and/or the total cost of the trade, “which is going to change in this environment.”

Until firms know “what that number turns out to be,” predictions about how the buy side will respond to the various competitors will be impossible, Bruel says. Firms will be focused on “which combination of clearing broker, clearinghouse, etc. will have the least impact from a cost perspective.”

As for the IT infrastructure perspective, firms will have to make adjustments, Hisler says. “You’ve got structural change in the derivatives markets,” he says. “You’ve got interest rate and credit default swaps that have traditionally used different trading systems, accounting systems, back office settlement systems and different documentation. They have been executed in different ways—over the phone, in more opaque less transparent methods.” If buy-side firms have IT infrastructures in place for their listed derivatives business, they might be able to adjust them to cover the new world of OTC derivatives clearing.

For the listed derivatives market, many firms have master clearing and execution agreements that are tied into systems for futures, equity-index futures and euro dollar contracts. It’s possible these systems can be adapted for OTC clearing. In addition, major IT vendors have been preparing for the onset of OTC clearing and the forthcoming demands for more data transparency, analysis and storage. Firms may also be able to run algorithms against the OTC clearing data that they will amass.

Even as the regulators forge ahead, though, the buy side may get more time to adjust to the new OTC clearing mechanisms because the rules may not be complete by the July 2011 deadline. In addition, partisan battles over Dodd-Frank may also lengthen the time-line as Republicans push for implementation delays and Democrats fight to keep the rulemaking on track. Barring the unforeseen, Cawley and Hisler estimate that OTC clearing for buy-side firms could begin in the fall of 2011.

“The fact remains that the same systemic risk sits in the system today as was in the system in 2008. We’re still dangerously exposed.”

— Jamie Cawley, CEO of Javelin Capital Markets and co-founder of the SDMA

 

Part of the problem may be the specifics of Dodd-Frank, says DeWaal from Newedge. “ I think Dodd-Frank provides a comprehensive framework,” he says. “But it’s much too detailed. It would have been better if it was more principle based. We think some of the delays and problems are because the law is so detailed.”

It’s also the case that the regulators and the industry are creating a third tranche—cleared swaps—to take its rightful place next to securities and futures. “At this point, the questions are: when will the regulations be finalized and what are the details? The devil is in the details.”

There are also devils in the marketplace where inevitably, the Davids of the world confront the Goliaths. There are no guarantees that the outcome will mimic the Bible story.

As the OTC clearing overhaul advances, the industry will be eager to see if the “cleared world” version of the OTC derivatives will be “as dominated by large institutions as the OTC derivatives market in a bilateral world is,” Bruel says. “In a bilateral world, balance sheet usage, which the large players have a huge advantage on, was a competitive differentiator when trying to trade with a counterparty.”

Yet the changes were inevitable as the industry needs more CCPs and electronic execution venues, Bruel says. “Innovation that is led by regulatory fiat is less effective than innovation led by market participants,” he says. The regulators have compressed a seven-to-eight year process into two-to-three years. “We would have gone to clearing. We would have gone to electronic execution venues anyway, in my opinion. It just would have taken a lot longer. So, is the regulatory compression of the timeline good or bad?”

The ultimate judge will be the market’s reactions.

Bruel says that while it’s correct to foster competition and encourage as many participants as possible, it boils down to the suite of services that brokers, execution brokers and clearing brokers bring to the party. They will have to offer market color, research, and advice on strategy and execution.

“So, creating a clearinghouse that allows some smaller brokers to clear is not the only requirement,” he says. If the small-to-mid-sized broker/dealers can create specialty and complementary services, then there will be market acceptance. “If it’s going to be a very niche service around clearing very specific instruments, then you might see order flow stay with the larger players.”

To prevent that scenario, the SDMA and its followers want to make certain that central clearing for CDS and IRS instruments gets off to a good start by facilitating more liquidity flow from the buy side and institution real checks on systemic risk. If those conditions take hold, a new OTC market could have a long life like the listed derivatives markets with multiple participants.

“We’ve done a good job of identifying that there are many independent firms with a lot of hard-working people looking to build their businesses,” Cawley says. “I think our message has been focused and is a sound and good one. I think it’s consistent with the needs of the marketplace and I think the buy side and Washington have been very supportive.”

The SDMA will continue to leverage its Washington connections as it leads the charge for OTC clearing reforms. In particular, the SDMA will oppose efforts to allow transactions to fall back into the “bilateral netherworld,” if they fail in the open clearing process, Cawley says.

The 10 Principles of the SDMA 

The Swaps & Derivatives Market Association (SDMA) has been organized around the following principles. More details about them can be found at http://www.thesdma.org/10principles.htm

1. Successful Clearing of Derivatives is Critical to Lessening Systemic Risk
2. Most OTC Derivatives are Eligible for Central Clearing
3. Broad Access to Central Clearing
4. Make Market Making Requirements for Clearing Firms More Inclusive
5. Objective Membership Standards
6. Market Price Transparency
7. Deeper Liquidity Lowers Transaction Costs and Spreads
8. Narrow Participant and Product Exemptions
9. Clearing Houses Must Ensure Open and Symmetrical Workflows
10. Truly Representative and Transparent Clearinghouse Governance

Source: SDMA

Trades that are rejected by the clearing process to come should be cancelled, Cawley says. Allowing them to loop back into a bilateral world “runs the risk of central clearing failing,” he says. “Dodd-Frank was clear on that. You don’t want this netherworld of contracts … If that became too large, that would threaten the integrity of the cleared marketplace.”

The association will also fight for continued firewalls within firms that separate trading and clearing operations. In a letter to the CFTC from Hisler, the SDMA threw its support behind a proposal for the adoption of regulations that require affected firms to establish “structural and institutional safeguards” and “appropriate informational partitions” between their internal and affiliate trading and clearing units.

“Given the artificial construct of requiring a dealer to self clear in order to execute a trade, Dodd-Frank and its subsequent rulemakings will create appropriate firewalls within a firm that separate trading from clearing,” Hisler says. “In other words, the workflows will operate more like the listed derivatives market where there are a multitude of independent liquidity providers and separate clearing firms to help distribute the risk.”

The ultimate test of whether the SDMA accomplished its main mission will come with the next financial crisis, Cawley says. “When a bank or a market participant fails in the future, we want to get away from a TARP situation where taxpayers have to bail out that institution,” he says. “I think a victory for the marketplace would be a lessening of the systemic risk … It’s not a question of if [a major firm will fail again], but a question of when.”

Read the sidebar to this article – SDMA vs. ISDA

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