This is a follow up to my piece "CFTC guidance on SEF access may be a game changer for OTC market infrastructure" here.

Executive Summary

• Regulatory reform delivers; finally
• New OTC derivatives market structure signalled by ICAP
• Further reduction in FICC trading incomes
• Investment banks to concentrate on intermediation or client facilitation
• New trading opportunities for speculative market participants leading to a compression in OTC IRS trading spreads
• Significant increase in number of trading tickets with commensurate reduction in notional value of trades – a boost for key derivatives CCPs and clearing members servicing market participants
• DCM to be less impacted but M&A indicates changes in B2C secondary market structure
• IDBs in play – 'when not if', how long will exchanges wait?
• Futures market not immune to change – HFT models under continuing scrutiny and liquidity provision schemes to be changed and potentially removed

 
As predicted, and following on from my note written in November last year, long overdue regulatory changes are finally bearing fruit as a new market structure develops in the OTC interest rate swap market.
 
The migration to an all-to-all model was signalled by ICAP yesterday in the pre-close trading statement and in a conference call with investors.

The scale of the industrial change was explained by Michael Spencer, “over time, we see the emergence of a new group of traders who will enter the space and take up the slack that has been left by the retreat of large numbers of investment banks. This will come from new independent trading firms – many of them algorithmic. The diminution of risk capability and market making capability at the sellside will mean the buyside will now need to look at other ways of executing and finding liquidity. This will offer another opportunity which hitherto has not been open to us.”
 
The multiple regulatory changes brought about by Dodd Frank, EMIR and Basle III is finally delivering a more transparent market model reflected in electronic trading, tighter spreads, central clearing and the more appropriate collateralisation of derivative exposures.

These numerous changes, not least the capital charges associated with warehousing OTC derivative exposures is causing a re-evaluation of FICC businesses at investment banks. Anecdotal evidence confirms that major players are migrating to either the intermediation or facilitation of client business. So firms will either act predominantly as principal or agent – for those of us old enough to remember, this heralds a partial return to a market model, which decades ago was known as ‘single capacity’.

The withdrawal of risk capital by investment banks and the downsizing of flow desks will provide substantial new trading opportunities for those with risk capital. These trading opportunities will not be limited to speculative hedge funds but will, in time, be available to US Commodity Trade Advisors (CTAs) and other futures market participants.

This will have a number of impacts – compression in IRS trading spreads to the benefit of end customers such asset managers/pension funds/insurance companies/corporates; a reduction in deal size but a commensurate surge in the number of trading tickets. This is a major potential boost to CCPs but their clearing member distribution and capacity of the clearing system are key dependencies.

My previous note sets out my view of the various Exchanges, CCPs and IDBs – the four key CCPs are well known: CME, ICE, Eurex and LCH/LSEG. I have nothing substantial to add to my earlier observations other than that Europe has created for itself a major competitive disadvantage by having futures risked on 2 day versus 1 day margin (background at Risk here). Also the slower and heavily politicised regulatory reforms in the Europe may in time prove to have been a major disadvantage if new market models take hold in the US as these will iterate out into other financial centres to the detriment of local market players. 

I continue to believe that IDBs will be bought by exchanges – the market structure changes indicate it is 'when not if'. How long can exchanges afford to wait? Of course they would prefer to see legacy bank flow migrate onto SEFs and similar platforms to allow greater certainty and reduction of deal risk before committing to M&A but of course life tends not to work out that way. Again, my view of the IDBs is set out in my previous note. The legacy voice businesses are a concern given new market models and with potential litigation risks but I anticipate Management Buy Out (MBO) solutions with Private Equity as potential investors.

The OTC IRS market structure will evolve and although change will also come to the Debt Capital Market, because of the fundamental structure, reflected in the number and diversity of issues, banks will continue to play the leading and valid role in DCM advisory, underwriting and warehousing of inventory. The recent M&A around Bonds.com, the DB acquisition of Bondcube and the purchase of Vega-Chi by Liquidnet indicate that market evolution is more likely to occur in the broker to client (B2C) space.

So, major changes in the interest rates derivatives market and new opportunities for all: be one of a liquidity provider, market operator, clearing member or clearing house. And most importantly, a more transparent market model with tighter trading spreads to the ultimate benefit of the end customer.

Finally, and closer to home, OTC market players will be pleased to hear that changes are also coming closer for the high volume HFTs, prop shops and futures arcades. The direction of reg reform is clear with HFTs under increased scrutiny. Ultimately I don't believe legal action will result because co-location and faster data feeds were available to all market participants, so in that sense there was no arbitrary restriction on participation, unlike other more 'club' like structures.

What is going to impact the high volume futures players is going to be changes to and the likely reduction in liquidity provision schemes and rebates. These have evolved way beyond their original purpose and regulators will want to see a more level playing field; and of course exchanges might even manage to increase revenue per contract (RPC)!

A trading strategy is hardly valid if profitability is based on the monthly fee rebate. Having said that I was more than happy to receive my scratch trade facility rebate back in 1986….