Friday, November 11, 2011

ISDA Finds Electronic Execution Mandate Would Result In Significant Costs, Little Benefit

The International Swaps and Derivatives Association (ISDA) recently conducted a cost benefit study on the Electronic Execution Mandate, which requires the execution of interest rate swaps on designated contract markets (DCMs) or swap execution facilities (SEFs). According to ISDA, the study indicates that the EE Mandate, in all likelihood, will bring little benefit to the market while adding significantly to the costs of using derivatives.

The research and analysis indicates that the electronic execution mandate will result in higher bid-offer spreads and significant costs, most of which will be borne by end users, said Conrad Voldstad, ISDA Chief Executive Officer. There is little to suggest that it may benefit any market participants. There is, to the contrary, much to suggest that it will take away users’ choice, create inefficiencies and discourage innovation.

ISDA retained NERA Economic Consulting to assist in research and analysis.

An exchange-trading mandate was generally imposed by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, with the objective of improving transparency and competitiveness in the pricing of OTC derivatives. The mandate is being implemented by CFTC rulemaking.

In particular, the rule proposal on core principles and other requirements for swap execution facilities has drawn significant industry objection to certain proposed requirements:

• Five-participant minimum. Market participants would have to execute a non-excluded transaction either by order-book or by transmitting a request for a quote to buy or sell a specific instrument to at least five market participants.
• 15-second delay. The proposed rule would subject traders who have the ability to execute against a customer’s order or to execute two customers against each other to a 15 second timing delay between the entry of those two orders, such that one side of the potential transaction is disclosed and made available to other market participants before the second side of the potential transaction (whether for the trader’s own account or for a second customer), is submitted for execution.

Alternative language for the provision that would not require a certain number of quotes or the 15-second delay was proposed by CFTC Commissioner Jill Sommers.

According to ISDA, there is excellent liquidity and competitive pricing in existing electronic platforms. Users of OTC derivatives currently have a choice of venues for execution. They have access to single- and multi-dealer electronic platforms, as well as voice execution. Despite the ease of execution and acceptable pricing, users freely admit they do not trade electronically very often. According to the study, they regularly obtain better pricing and much larger size by calling one or more dealers requesting an improvement in the quote or a price for larger size.

The analysis found that the electronic execution mandate and the proposed new regulatory framework will limit choice for end-users and ultimately increase transaction costs. Specifically, the study estimates that possible benefits for small end-users will be no more than $1,000 for a $10 million interest rate swap before fees for execution and clearing, while initial and ongoing costs will amount to approximately $1,300 per transaction. Thus, any net benefit for small end-users will be dramatically outweighed by costs to the market as a whole.

According to the study, the mandate will not achieve the goals of transparency and competitiveness. With mandatory clearing, the credit risk of small users will be eliminated, and therefore small end users will be approved for execution of swaps on dealer platforms.

The mandate may result in marginally better transparency of pricing as pre-trade prices will be shown on DCM and SEF platforms rather than dealer, broker and data provider screens. However, the benefit may be marginal, because several single- and multi-dealer platforms already display real-time quotes. Also, new post-trade transparency requirements, in the form of real-time reporting of trade information, will reduce liquidity, increase costs, and provide only questionable benefits to small derivatives users.

The study finds that derivatives users believe restrictive provisions in the proposed rules such as the 15 second rule, the requirement for at least five participants to quote through a request for quote (RFQ) platform, very high block trade thresholds and very short block trade reporting delays will negatively impact liquidity and push transaction costs up further.

Overall, ISDA believes the EE Mandate will not meet its objectives. It will result in higher bid/ask spreads and significant operational, technological and compliance costs, and may force some participants from the market.

The post is from my colleauge Lene Powell