Via BAML: On June 10th, category two OTC market users (primarily the buyside) in the U.S. will be required to comply with mandatory OTC (over the counter) clearing, which was passed within the Dodd-Frank legislation a few years back (unless there’s an extension). This event marks the second (and most important) key date of a three phase roll-out that began in March and ends in September. In this note we discuss what occurred after the category one date in March, what we expect for category two, & the range of opportunities for the exchanges / clearinghouses, as well as the potential impact to the brokers and asset managers. That said, in the near term, we expect interest rate uncertainty and a pick up in overall volatility to continue to be the primary driver for the sectors.
Over the past month, clearing activity has been ramping up at the clearinghouses as category 2 clients’ position for the upcoming deadline. While we believe the major users are positioned for clearing, smaller users are less prepared, which could create some near term issues, lower volumes, or see a potential extension.
We continue to believe that the OTC clearing mandate will be a long term opportunity for the clearing houses and exchanges, given the potential clearing revenues (<5% to revenues), opportunities for transaction / market data revenues longer term (modest), as well as a portion of the market transitioning to futures like products (which has mostly occurred in energy), which we estimate could be ~25%+ of the non-dealer market (adding ~5%+ to futures volumes over time).
Given that the markets will be competitive & that increased regulation can change volume levels, it is tough to pinpoint the opportunity. We estimate the U.S. clearing opportunity to be between $100M-$250M and the global opportunity to be between $200M-$500M (’14-’15 and beyond, ~3%-7% of the combined revenue base of CME & ICE/NYX), though there could be some downside risk on lower volumes & competition, given that there are four main competitors currently (CME Group Inc (NASDAQ:CME), Deutsche Boerse AG (ETR:DB1) (FRA:DB1) (OTCMKTS:DBOEY), IntercontinentalExchange Inc (NYSE:ICE)/NYSE Euronext (NYSE:NYX) (EPA:NYX), & LCH). That said, there could be upside longer term from higher volumes or a portion of the dealer market being bid away, though this is less likely given the fee structure. Finally, in the near term, we expect the pick up in volatility to matter more for the sector, & there are a few risks to monitor over time (being systemically important, netting benefit risks, and potential changing market structure).
For the brokers, we view clearing alone as a modest headwind (~4% hit based on recent JPMorgan Chase & Co. (NYSE:JPM) disclosure of all regs ex volcker) – given the cost and potential volume and margin impact (though it could rise to 5-10% over time if more volume shifts to future alternatives). That said, volumes have already been low and we could see an improvement/offset as Central Banks exit markets and volatility normalizes. As clients transition to mandatory clearing, we do expect a few of the leading dealers to gain a first mover tech advantage (including Goldman Sachs Group, Inc. (NYSE:GS)), earn additional revenue on collateral management, and take out costs as the market transitions (as we’ve seen in the past with markets facing regulatory and technological changes). For the asset managers, we expect modestly higher tech/reg costs, but most of the impact will be felt by fund investors via lower returns if trading costs rise.
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While there is a focus on the OTC changes given the upcoming date, given the potential for Central Banks to pull back from markets and volatility to pick up, we expect that to be the main driver for the exchanges and brokers, in the near term.
Swap execution facility rules finalized
Since category one participants became required to clear on March 11, the CFTC has finalized and approved a number of rules related to swap execution facilities (SEFs), which were generally inline with expectations, giving market participants increased clarity as the mandatory OTC clearing environment continues to evolve. One of the few remaining areas that the CFTC did not provide clarity on pertains to aggregators, which is expected when the final rules are published later this year. The rules will become effective 60 days after its publication in the Federal Register, and the CFTC, in its discretion, has set a general compliance date of 120 days following publication. The exact date the rules will be effective depends on when the CFTC publishes the rules in the Federal Register. The final rules that were approved since phase 1 include:
Procedures to Establish Appropriate Minimum Block Sizes for Large Notional Off-Facility Swaps and Block Trades (Swaps Block Rule): Minimum block sizes will be determined using a 50% notional amount calculation initially and a 67% notional amount calculation thereafter. Initially, the CFTC will determine the block size and then swap data for each asset class will be used to determine minimum block sizes after the initial period.
Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade under Section 2(h)(8) of the Commodity Exchange Act (CEA); Swap Transaction Compliance and Implementation Schedule; Trade Execution Requirement Under Section 2(h) of the CEA (Made Available to Trade Rule): A SEF or DCM determines whether a particular swap should be available to trade based on 1) whether there are ready and willing buyers and sellers; 2) the frequency and size of transactions; 3) the trading volume; 4) the number and types of market participants; 5) the bid/ask spread; or 6) the usual number of resting firm or indicative bids and offers.
Core Principles and Other Requirements for Swap Execution Facilities: Provides that required transactions that are not block transactions must be executed on a SEF through an Order Book or a Request for Quote System (RFQ) that operates in conjunction with an Order Book. For permitted transactions, a SEF can offer any method of execution, including voicebrokering. If a SEF uses an RFQ system, swap users must request a minimum of two quotes from dealers initially and three quotes after one year, which was reduced from five RFQs in the original proposal.
Anti-disruptive Practices Authority – Interpretive Guidance and Policy Statement: Prohibits participants from 1) violating bids or offers; 2) demonstrating intentional or reckless disregard for the orderly execution of transactions during the closing period; or 3) bidding or offering with the intention of cancelling before execution.
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OTC: Phase 2 of mandatory clearing
The first deadline for mandatory clearing of IRS and index CDS for category 1 financial institutions (which included swap dealers (SDs), security-based SDs, major swap participants, major security-based swap participants, and “active funds,”) passed with somewhat limited fanfare but now other derivatives market participants, including buy-side institutions and non-swap participants, must prepare to meet the upcoming mandatory clearing deadlines under Dodd-Frank.
Firms classified as either category 2 or category 3 participants have until June 10th or Sept 9th, respectively, to prepare for mandatory clearing. The size of the group of firms that fall under the definition of category two participants is estimated to be as many as 2,000+, which compares to around 50 firms (albeit large firms) that began clearing at the March 11 deadline. Given only one of the three deadlines has passed thus far and the category one participants were large OTC users that already had significant experience clearing, the remaining phases are likely to be more eventful.
The remaining OTC clearing mandate timeline is as follows:
Category 2: June 10, 2013
- Commodity pools, private funds (who are not active), and persons that are “predominately engaged in activities that are in the business of banking, or in activities that are financial in nature as defined in section 4(k) of the Bank Holding Company Act” (except for non-third party subaccount structures).
Category 3: September 9, 2013
- All others subject to the mandate (i.e. non-commercial end users hedging commercial risk), pension funds, and any entity with a third-party subaccount structure.
Given the timeframe of the remaining regulatory thresholds, 2013 will be an important year for OTC clearing. The challenge in figuring out how it all plays out is that each market has different characteristics and each user has different priorities. In addition, given the various options available to users, including continuing to operate in the OTC markets, transitioning to a current futures product, or adopting a new futures type of product, it is even more confusing. The only certainty is that there likely won’t be any for awhile, and the market will likely transition in many different paths. Therefore, in order to ensure a share of the opportunity, most serious players will have to offer all choices to the market.
The OTC market and clearing opportunity
The OTC market is large, at more than $600 trillion in notional value, roughly 10x the size of the exchange traded derivatives market. However, given the nuances and lack of liquidity in the OTC interest rate market, the turnover level is significantly less, at less than 25% of the exchange traded interest rate derivatives market. The OTC market experienced significant growth over the years, but has somewhat stalled post the financial crisis. The largest OTC markets are those for interest rate swaps (IRS), foreign exchange, and credit default swaps (CDS).
Consequently, we believe these markets represent the largest revenue opportunities for the exchanges/clearing houses (though given some of the FX exemptions, it’s likely a smaller opportunity). While it remains an opportunity, it is a different market than futures. Based on the size of the markets, turnover, user mix, and pricing, we estimate IRS clearing could represent $200-500M+ (Table 1) in clearing revenue for the market while CDS could represent an additional $30-80M+ (Table 2), though volume levels and competition (pricing/market share) could meaningfully alter the size.
