Contributor: Stephen Nimmo
This blog post originally appeared on DerivSource.
When the CFTC releases each new Dodd-Frank (DFA) rule, the agency starts with an overview describing the rule’s purpose. To paint the picture, here is a snippet of the CFTC’s overview summarizing the reasoning behind the DFA in its entirety:
“The legislation was enacted to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things: (1) Providing for the registration and comprehensive regulation of swap dealers and major swap participants; (2) imposing clearing and trade execution requirements on standardized derivatives products; (3) creating robust recordkeeping and real-time reporting regimes; and (4) enhancing the Commission’s rulemaking and enforcement authorities with respect to, among others, all registered entities and intermediaries subject to the Commission’s oversight.”
While each of the CFTC’s four main DFA principles are important, the clearing and trade execution requirements on standardized derivatives products will be the biggest game-changer for all derivatives trading participants. While most energy market participants are trying to figure out how they will register with the CFTC, what an SDR is, or whether their current ETRM system is able to magically solve their Dodd-Frank problems, they may be ignoring the most important question.
How will our trading activity change after Dodd-Frank? This question may be difficult to answer completely.
We know the first general rule of Dodd-Frank is that swaps that can be cleared should be cleared. Where many swaps can be standardized, thus homogenized across platforms, swaps will move into a cleared model, transferring counterparty credit risk into the clearing houses. By moving the risk away from the counterparties involved in the transaction, this change will reduce the amount of systemic risk – and pain – that would occur if an entity files for bankruptcy.
But along with this benefit comes the cost of trading cleared versus uncleared transactions. For some trading activity, the additional costs of clearing the trade may make certain profitable trades unprofitable, reduce liquidity in the market, widening the bid/ask spread. For some entities, moving to a cleared model simply means a higher cost of doing business, and these additional costs will trickle down to the consumer or even create more uncertainty if margining becomes too expensive and the participant chooses to do nothing.
The second general rule of Dodd-Frank is that transactions that can be executed electronically should be executed electronically. This change is still blurry, as we have not yet seen the entrance of new swap execution facilities (SEFs). These new entities are designed to be electronic marketplaces for swaps, moving much of the bilateral swap trading activities into central locations for greater price transparency and access. Essentially, for certain swap trading venues with enough liquidity, the SEFs will be able to register as an execution facility for the product and begin to allow trade executions. These SEFs will play a critical role in swaps trading, where open interest, bid-ask spreads and volumes will add to pricing and transaction data quality.
Finally, another thing to keep in mind is if swaps can neither be cleared nor executed on a swap execution facility because a SEF or clearing house does not exist for that instrument, then the onus for margining and swap data repository (SDR) reporting is on the transaction participants themselves; thus, creating the large resource investment in Dodd-Frank compliance implementation. Whether a swaps end-user or swaps dealer, few appear ready for this paradigm shift in trading and regulatory reporting.
Ultimately, how will these changes affect energy market participants? Consider these changes on the horizon that will affect the ways companies engage in trading activities:
- Moving from credit-risk-heavy bilateral trading will cause additional capital requirements for organizations to meet margin requirements.
- Companies will need complex, near-real-time analytics and tools to evaluate and monitor counterparty margin requirements.
- Voice brokered financial swaps will move exclusively to SEFs.
- Proliferation of execution platforms will mean a need for additional electronic connectivity from market participants wanting to engage in certain trading activities.
- An explosion of market data from SEFs for price discovery, valuation and risk will prove valuable if managed effectively.
- Any trading activities which heavily utilized bilateral swap trading will need organizational review of how they should continue within the new market structure.
It is clear that the energy derivatives trading landscape will be drastically altered as Dodd-Frank continues to force more and more change across the industry. Anticipating these changes and making the right decisions and investments today will help energy market participants to prepare for a competitive tomorrow.