The buy-side should expect some short-term disruption to their business as regulatory change takes hold in the US fixed income market, according to a report from Greenwich Associates.
Changes mandated in the Dodd-Frank Act, including central clearing and the switch to electronic trading via swap execution facilities (SEFs) will push up costs for buy-siders.
The clearing business model was highlighted as a key issue likely to push up costs, as most dealers do not see clearing as a profitable business on a stand-alone basis. Clearing dealers may push for higher fees through funding charges, capital usage fees and increased notional-based transaction costs.
Greenwich expects institutional investors may begin to concentrate their clearing business with a small number of clearing brokers in order to benefit from volume discounts and margin efficiencies.
Additional disruption could result from the move from bilateral to cleared trades and while buy-siders should benefit from greater transparency, there are likely to be growing pains and delays as the market adapts.
However, there are also significant benefits of regulator change for the buy-side over the longer-term.
The more simplified trading process that clearing brings should make end-to-end trade flow much faster and more efficient, the report said, which will reduce implementation shortfall and cut operation errors. This should ultimately provide higher returns for fund investors.
Also, while costs will initially rise, in the mid- to long-term, there will be cost savings to be realised by the buy-side as well. As counterparty credit risk will be eliminated, some investors will see costs fall as they gain access to larger groups of dealers. Those dealers who might only have traded with larger institutions in the past will now provide liquidity for smaller buy-side firms.
Similarly, administrative costs will be reduced as investors will not need to negotiate separate International Swaps and Derivatives Association (ISDA) agreements with every counterparty.
Some buy-siders remain worried, however, as rising interest rates, increased capital requirements for banks and derivatives regulations could lead to a contraction in the number of fixed-income dealers in the market in the coming years, which could hit overall liquidity.
The introduction of SEFs is set to transform the relationship between the buy-side and sell-side, the report added.
Currently, the fixed income market is highly focused on request for quote (RFQ) and voice trading models, but the introduction of SEFs will push central limit order book-based, anonymous models of electronic trading onto the marketplace.
This will cause the sell- and buy-side to drift apart as they will not directly interact, as even voice trades will be conducted via a SEF.
Kevin McPartland, principal at Greenwich Associates, said the model will completely change the industry: “Although mandatory SEF trading will fundamentally change the way buy-side swap traders interact with the dealer community, the ultimate result will be a positive one, especially for smaller and midsize asset managers.”
With the introduction of electronic trading of fixed income derivatives, the sell-side will no longer be able to pick and choose who they deal with, having typically favoured bigger institutions in the past.
“[The buy-side] will benefit from tighter spreads and access to more liquidity providers than were available to them in the OTC market,” added McPartland.