The swap market has survived the transition to swap execution facilities (SEF). The final regulatory tool put in place by the Dodd-Frank act to rein in the $693 trillion over-the-counter (OTC) derivatives market became mandatory on February 15, and despite an initial drop in trade volume swaps have recovered in the weeks since then.
“Leading up to the February 15th deadline (Feb 26 for credit default swaps) there was concern in the marketplace about client and dealer preparedness as well as SEF liquidity,” write Citi analyst Keith Horowitz in a March 19 report. “Initial impressions were in-line with expectations for volumes to dip in the first few days, but trading activity has improved more recently.”
Drop in volume not entirely due to swap execution facilities
Total swap volume, including interest rates, forex, and credit derivatives, fell both during the week before and week after SEF trading became mandatory, but levels have quickly normalized and are now only slightly depressed compared to six weeks ago, and look like they will soon cross $1 trillion in notional value again.
The drop in volume after SEF trading became mandatory was expected, but the week prior is harder to explain as an impact of the new regulations, and the two week decline could be partially unrelated.
“The decline in Swap flows in 2014 was very similar to the decline in Treasury flows (which are close substitutes for duration),” writes Horowitz. “The decline in flows may not be completely SEF related.”
Investment banks still expect long-term headwinds
A smooth transition to SEF trading is good news, but investment banks still expect the new regime to cost them money. JPMorgan Chase & Co. (NYSE:JPM) estimates that it will lose $1 billion in revenues this year because of the change, down from an earlier estimate of $1 billion – $2 billion, as traders opt to trade in the futures market instead of making rates swaps. It’s still quite early, but so far there hasn’t been a rush to swap futures, though investment banks will be keeping a close eye on these volumes.
Investment banks will also likely see their profits fall because of spread compression. Horowitz says that other asset classes have seen the bid/ask spread drop by 75% over time after making a similar move to greater price transparency. This effect will be gradual as other agents enter the market and competition increases – spreads actually grew last month because of higher political and macro uncertainty – but it’s hard to see why this asset class would behave differently in the long run.