JPMorgan Chase & Co., Goldman Sachs Group Inc., and the world’s largest banks won rollbacks in final Dodd-Frank Act rules that promise to transform the private swaps market by increasing competition.
The Commodity Futures Trading Commission voted 4-1 in Washington last week on rules determining how buyers and sellers must trade credit-default, interest-rate, and commodity swaps in a $633 trillion global market. The rule weakened a proposal by reducing the number of price quotes buyers must seek on swap-execution facilities, after banks and asset managers said a five- quote requirement was onerous and would impair trading.
The vote on the rules represents “the start of a process that could eventually lead to a seismic change in trading of over-the-counter derivatives,” Richard Repetto, an analyst with Sandler O’Neill & Partners LP in New York, said in a telephone interview before the meeting. “It is a switch from an opaque, bilateral market to something where there is some price transparency and a more open and automated market.”
The trading regulations are the latest step in efforts by the CFTC and Securities and Exchange Commission to curb risk and increase transparency in the swap market. Largely unregulated trades helped fuel the 2008 credit crisis that led to the collapse of Lehman Brothers Holdings Inc. and a U.S. rescue of New York-based American International Group Inc.
CFTC Chairman Gary Gensler has pushed for rules to improve competition by shifting the “information advantage” away from Wall Street banks.
“This rule significantly benefits mid-market America, mid-market pension funds, mid-market insurance companies, community banks, small corporates,” he said after last week’s vote.
Five Wall Street banks dominate the U.S. swaps business with JPMorgan, Goldman Sachs, Bank of America Corp., Citigroup Inc., and Morgan Stanley controlling 95 percent of cash and derivatives trading for U.S. bank holding companies as of Dec. 31, according to the Office of the Comptroller of the Currency.
The rules may erode bank profits by reducing their current ability to trade directly with other banks or clients in the bilateral market. The trading, clearing, and other rules may cost JPMorgan $1 billion to $2 billion in revenue, according to a Feb. 26 presentation by the bank.
The rules represent the final definition of a new type of trading platform set up under Dodd-Frank that is intended to serve as an alternative to exchanges operated by CME Group Inc. and Atlanta-based Intercontinental Exchange Inc. Bloomberg LP, the parent company of Bloomberg News, has filed a lawsuit challenging a separate CFTC rule that the company said will harm its planned swap-execution facility. Tradeweb LLC, Icap Plc, and GFI Group Inc. have said they plan to set up so-called SEFs.
Dodd-Frank would have most swaps traded on SEFs or exchanges that let buyers and sellers interact with multiple participants. About 80 percent of interest-rate swaps will be guaranteed at clearinghouses and traded on SEFs, Credit Suisse AG analysts Ira Jersey and Michael Chang estimated in a May 2 note.
“The ground has been plowed and turned. Now it’s up to market participants to see what we can grow here,” said Shawn Dorsch, president of Charlotte, North Carolina-based Clear Markets Inc., an electronic swap-trading company.
CFTC commissioners changed the proposed quote requirement after talks faltered late last year over the plan to mandate five quotes. JPMorgan, Deutsche Bank AG, and other swap dealers lobbied against the five-quote requirement, telling regulators that it is unnecessary, will increase trading costs and reduce liquidity on facilities using request-for-quote systems.
Buyers of derivatives represented by the Securities Industry and Financial Markets Association, International Swaps and Derivatives Association Inc., and Managed Funds Association told regulators they wanted a one-quote requirement and would consider using other markets if the five quote requirement was put into place.
The final rules require buyers to request at least two quotes initially and then three quotes after a phase-in process, according to a CFTC official. Gensler agreed to the quote compromise after failing to persuade Republican and Democratic commissioners that five were needed. The three-quote requirement would begin in around October 2014.
“It is going to be perceived as a win for the dealers, especially the two included in the RFQ,” Sunil Hirani, chief executive officer of the trueEX Group LLC swap-trading platform, said in a telephone interview. “I see it as a capitulation for those who wanted a higher number.”
In a statement after the vote, Sifma said it still strongly disagreed with the final CFTC rules and the minimum vote rule.
Mark Wetjen, one of three Democratic commissioners, said the rule provides flexible trading protocols that represent a “fundamental shift” away from market practice. “‘Flexible trading protocols’ is not code for ‘status quo’ as some might suggest. It is not code for ‘pro-dealer’ trading protocols,” Wetjen said.
In addition to the RFQ measures, the rule requires trading platforms to have an order book available to all market participants. Those bids and offers would be communicated to the rest of the market.
“Nothing in the statute mandates these minimum trade functionalities. We made them up,” Jill Sommers, one of two Republican CFTC members, said at the meeting. “I believe we will regret this restrictive approach because it may cause the U.S. to lose this business to foreign jurisdictions that do not stifle illiquid contracts in this way.”
The final rule would also allow companies that execute trades over the telephone or any form of technology to operate as SEFs. Brokers such as GFI and Icap, which facilitate trades between banks, lobbied the agency to permit trades conducted by voice and not require electronic-only methods.
“These are short-term gains for the status quo,” James Cawley, CEO of Javelin Capital Markets LLC, said in a telephone interview. “The market is moving to cheaper and more electronic trading of swaps. The argument that the products are bespoke and too complicated to be traded on a screen are unfounded.”
A separate rule approved on a 3-2 vote sets the threshold for when trades are large enough to be traded off the platforms in transactions known as blocks. The rules for blocks also allow for a phase-in process.
Under the rule, a trade would be considered a block if it is larger than the 50th percentile for notional value in a given category of swaps. Starting in April, the threshold would rise to the 67th percentile. About 14 percent of interest-rate and credit swaps might be traded as blocks until the higher threshold takes effect, a CFTC official said.
The CFTC rejected two amendments offered by Scott O’Malia, a Republican commissioner, to require the CFTC to conduct further study of swap data to determine block thresholds. The final rules impose an “arbitrary and automatic increase” in the threshold based on limited data, he said.
The CFTC voted 3-2 on a separate rule governing how SEFs and exchanges determine which swaps are made available for trading. The CFTC’s ability to review the determinations is limited under the rule, according to Sommers.
The rule will “bind the entire marketplace to a trade execution requirement as long as the swap must be cleared, even if liquidity is lacking,” she said. “This is overly broad, potentially inconsistent with foreign regulations, and just plain bad policy.”
The commission also voted unanimously to publish guidelines about how the CFTC plans to combat disruptive trading practices, such as action during a closing period that has an intentional or reckless disregard for orderly execution.