Dealer revenue from negotiating interest-rate swap transactions is poised to plunge about 45 percent as new rules boost trading costs, pressures that may prompt banks to participate less in the $633 trillion over-the-counter derivatives market, Tabb Group LLC estimates.
Banks collect about $3.25 billion a year from trading rate swaps with their customers, Tabb said. That revenue will shrink to $1.8 billion in 2014 as most transactions shift to public markets, according to a research report meant for Tabb customers that Bloomberg News obtained. Dealers will also need to hold more capital to back trades, boosting expenses, said Will Rhode, who wrote the report.
“There probably will be some painful conversations at the end of 2013 about how much this business costs to run,” Rhode said in a phone interview. While increased electronic trading will reduce transaction sizes and lead to more trades, it won’t be enough to offset lost profits, he added. “There’s no way the turnover increase can be sufficient enough to make up for the revenue shortfall,” he said. “These products that were basically free have just become much more expensive.”
The 2010 Dodd-Frank Act mandated that swaps trading shift to public markets, away from privately negotiated transactions. The change was meant to increase transparency and competition by shedding light on a market where banks used to take one side of every transaction.
The latest phase in the process began two months ago, when the new public trading platforms -- known as swap-execution facilities, or SEFs -- began operating. Eventually, 50 percent of all interest-rate swaps and 25 percent of credit-default swaps trades will take placed on those systems, Rhode estimated.
The Tabb report was based on 50 interviews with asset managers, hedge funds, banks and insurance companies that buy and sell interest-rate and credit-default swaps. It also used proprietary data and information available from SEFs, clearinghouses and swap data repositories.
Banks fought the transition to electronic trading out of concern it would reduce their profits. JPMorgan Chase & Co. said this year that it will lose $1 billion to $2 billion of annual revenue because of the reforms. The New York-based bank earned $5 billion in 2008 trading over-the-counter fixed-income derivatives, including swaps, after the collapse of Lehman Brother Holdings Inc. widened bid-ask spreads.
Dodd-Frank also required that most swaps be backed by clearinghouses for the first time, a response to the 2008 credit crisis that the derivatives helped cause and intensify.
Swaps dealers currently get about 95 percent of their revenue from trading fees and from profiting off the difference between bid-ask spreads, Rhode said. The remaining 5 percent comes from fees associated with clearing. The latter figure will quadruple because bank customers will be required by law to clear their trades, while the former declines as spreads narrow, he said.
The shift to clearing presents both opportunities for banks to earn revenue and added costs, Rhode said.
Clearinghouses, which are capitalized by their bank members, are meant to lessen systemic risk by requiring margin to back every trade in case a user defaults. They monitor prices throughout the day and demand cash for losing positions so that losses don’t build.
Banks charge their customers for handling the margin that is sent to the clearinghouse, Rhode said. This additional revenue may be large, though it’s offset somewhat by the cost of capital a dealer must use to run a clearing business. For example, swap brokers are required to set aside their own cash to act as a buffer in case their customers can’t make intraday margin calls.
“With clearing, it’s that they’re charging for deployment of balance sheet,” Rhode said in the interview. “Being a clearer of swaps is very capital intensive.”
Because of Dodd-Frank, swaps customers will have to post $800 billion to $4.6 trillion in additional collateral at clearinghouses, according to estimates from the Treasury Borrowing Advisory Committee.