Why leave ‘til tomorrow what you can do today? One reason, it seems, is that you can never be sure what tomorrow might bring.
Many large-volume swap market participants on the buy-side, i.e. large hedge funds and asset managers, made the decision some time ago to register as swap dealers or major swap participants under Dodd Frank on account of their historical and likely future appetite for the kinds of swaps that must be centrally cleared from 2013 onward.
Clearly this would seem the sensible, ‘good citizen’, thing to do. But delays in the regulatory process mean there are fewer certainties about the cleared OTC derivatives markets than participants would like. But that deadline isn't getting further away so let's do what we can to prepare by registering, right?
Well, not necessarily.
What if a means arises of reducing your swaps trading activity so that you can avoid being captured as a major swap participant or swap dealer?
Courtesy of the CME and ICE, the US derivatives exchanges, such means are emerging and are being taken advantage of by a number of buy-side firms. Both exchanges are offering ways of reducing the number of OTC swaps the buy-side conducts, the most prolific of which being the commodities swaps that ICE has already migrated to its futures segment. The CME will launch interest rate swap futures contracts in November but it remains to be seen whether these will be as popular as traditional interest rate swaps.
Large buy-side firms are looking into whether using these instruments instead of traditional swaps could allow them to explore the possibility of de-registering as a swap dealer or major swap participant if they prefer to wait and see how their obligations will change under the rules or if they are already considering a switch from swaps to futures so they can avoid the cost hike associated with OTC derivatives reform.
This is perhaps not too surprising. Institutional investors have always been more comfortable taking a more passive role in the financial markets, letting the sell-side bear the costs and the risks of execution as much as possible.
The equity market practice of capital commitment is founded on the willingness of the sell-side to charge a price for risk-transfer. In many emerging Asian markets, the slow take up of execution algorithms can be traced in part to the reluctance of the buy-side to take greater responsibility for their own trades.
With the reforms to the OTC derivatives markets, buy-side firms have been confronted with a number of questions over their responsibility for execution and clearing of derivatives trades. Should they connect directly to swap execution facilities (SEFs) or ask their brokers to serve as SEF aggregators? Should they set up their own repo desks or select the collateral transformation services being offered by custodians and other sell-side institutions? Should they act as price makers as well as price takers in the electronic marketplaces that are already springing up?
Tomorrow never knows, but – if the question of registering under Dodd-Frank is any guide – perhaps OTC derivatives reform will in at least one aspect prove less revolutionary than expected. Traditional roles may well be maintained with the sell-side taking the risk and the buy-side paying the premium.