New transparency rules: the devil is in the detail
04 Oct 2010
The derivatives industry might feel it has emerged from the first round of regulation in better health than seemed possible several months ago, but no one in the industry is celebrating just
The ramifications of the US Dodd-Frank Act and the prospective European legislation are not clear and the devil is in the detail. In the US, interpreting Dodd-Frank has been left to the two main
regulators – the Securities and Exchange Commission and the Commodities and Futures Trading Commission. The SEC will oversee so-called security-based swaps, as befits its role as the securities
regulator, and the CFTC will have jurisdiction over everything else, including interest rate swaps.
A security-based swap is defined in Section 761 of the Act as any agreement, contract, or transaction that is a swap and is “based on a narrow-based security index, a single security or loan, or
the occurrence, non-occurrence, or the extent of the occurrence of an event relating to a single issuer of a security or the issuers of securities in a narrow-based security index, provided that such
event directly affects the financial statements, financial condition, or financial obligations of the issuer”.
This unnecessarily laborious and opaque definition is taken to mean credit default swaps, perhaps the most reviled and distrusted of all the derivatives that have been in the news over the past several years.
Given the ambiguity surrounding the way in which the law passed by Congress will be interpreted and implemented, it is interesting to speculate on the current thinking of those in positions of
Mary Schapiro, chairman of the SEC, gave just such a glimpse when she spoke to the Securities Traders Association on September 22. The challenge for the SEC, as Schapiro sees it, is to “cultivate”
a market structure for security-based swaps “that reflects the virtues of the current equities market: competition, access, liquidity and transparency”.
We should be grateful to Schapiro for this insight, but it is alarming rather than reassuring. In exactly what way the equities market is similar to and should serve as a blueprint for a new derivatives industry is, at this stage, somewhat mystifying to all except the SEC.
She went on to say that incorporating the same degree of transparency that exists in the equity market will produce greater liquidity and lower transaction costs. To enhance this transparency, all
security-based swap trades will be reported immediately in real time.
The regulators are very keen on transparency at the moment, but whether this will result in lower costs and greater liquidity through all aspects of the derivatives market is not proven. Dealers
worry that markets in which there is currently low liquidity will simply cease to exist if marketmakers are forced to expose their positions for all to see.
In the CDS market, for example, index trades could be cleared and revealed without any particular loss of competitive advantage and subsequent liquidity. The market is by now sufficiently well
developed and deep to have become largely commoditised anyway.
But liquidity in single name CDS is often far less reliable. Some single name entities trade only once in a blue moon and even those credits that trade more regularly suffer periods of torpor. In
a market which is thin and illiquid, dealers will be extremely reluctant to post positions if these can be seen by all. The market would be likely to shy away like a frightened pony, leaving the
dealer exposed. It has become axiomatic among regulators that greater transparency will be better for customers but if dealers don’t make markets in illiquid instruments then end-users will not be
This is true of other derivatives markets as well as single-name CDS. Even the highly liquid instruments are not as liquid as one might think. Throughout the month of June, for example, there was
an average of 4,300 interest rate swap transactions per day; the volume of daily trades in the listed derivatives market would have been many multiples of that figure.
In some areas of the interest rate and currency swap markets, illiquidity continues to rule. Posting a position at the ultra-long end of the interest rates market (20 years and beyond), is a
hazardous and nervy business for any dealer.
This is germane, because the long end of the market in sterling and euros is beginning to see a little more business lately. Rates are so low that European borrowers are keen to term out debt for
as long as possible. In most cases, they place debt in sterling – where demand for long-dated assets is strongest – and sometimes swap back to euros.
In the week before last, for example, Gaz de France issued a £700m 5% bond due 2060. This was the largest-ever 50-year deal from a corporate borrower, and GDF confided that it had achieved an
“average rate of 4.28%” from the offering, so we know it was swapped to fixed-rate euros.
The deal would be hedged from fixed sterling to floating sterling via an interest rate swap, from floating sterling to floating euros via the basis swap market and then from floating euros to
fixed euros through another interest rate swap. All this had to be accomplished at the long end of the market, where liquidity is thinnest. The size of the deal was far from insignificant
Multiple layers of spread trades in addition to outright positions were used to complete the hedge and, throughout the process, dealers and brokers had to move very warily lest the market spin
away from them. It seems that this was accomplished adroitly; indeed, so subtle were some legs of the trade that prices hardly moved at all. Observers not in the know were left scratching their heads
as to whether the trade had gone through or not.
This would not have been possible in a market where everyone knows what everyone else is doing. If the regulators make a god of transparency, then this sort of trade would result in greater transaction costs rather than lower ones – transaction costs that will be passed on to the customer and ultimately to the shareholder.