We have examined in previous years a variety of structural issues in the swaps market that discourage new entrants from stepping into the fray. The capital intensity of the business is the primary one, but details being debated this year as swaps trading rules are in flux-such as post-trade name give-up, the ability to trade via "any means of interstate commerce" and moving toward a market where RFQ to 1 is explicitly permitted-are worthy of deeper examination.
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The interest-rate swaps (IRS) business in the United States remains concentrated. The top five interest-rate derivatives (IRD) dealers handled 63% of buy-side trading volume in 2018, and the top five clearing brokers held 75% of customer margin as of October 2018. While the reasons for this are multifaceted, the driving force of increased concentration is regulation. Concentration began to grow once swaps clearing and trading rules were put in place under Dodd-Frank. More recently, Greenwich Associates data shows that trading with the top five dealers has also increased in Europe, from 40% in 2015 to 48% in 2018, as MiFID II rules were finalized and implemented.
But while the importance of the top banks is quite clear, the market should always encourage competition. We have examined in previous years a variety of structural issues in the swaps market that discourage new entrants from stepping into the fray. The capital intensity of the business is the primary one, but details being debated this year as swaps trading rules are in flux—such as post-trade name give-up, the ability to trade via “any means of interstate commerce” and moving toward a market where RFQ to 1 is explicitly permitted—are worthy of deeper examination. And while equity, FX, U.S. Treasury and, most recently, corporate bond markets have seen an influx of new liquidity providers, new entrants in the swaps market that are still standing can be counted on one hand. Furthermore, some regional and middle market dealers have managed to gain share in certain markets such as corporate and municipal bonds, but the barriers to entry in these swaps markets have largely kept these same players away.
What is perhaps more important to the entire market, however, is whether or not this concentration creates systemic risk concerns. The answer, just like capital rules, is complicated.
Trading Concentrates with Top Dealers
Trading concentration within the top five global dealers is up in nearly every over-the-counter asset class—from corporate bonds to government bonds to swaps. While signs of increased competition among dealers ramped up as Dodd-Frank rules were written in 2012–2013, lawmaker aspirations were ultimately not enough to keep new entrants in a business that did not generate a sufficient return on equity.
Further, as dealers have right-sized their businesses over the past decade, they have reduced the number of clients they were willing (and able) to service and also limited exactly what services each of those clients would receive. Only platinum clients would gain access to the full team of research analysts, market color and—most importantly— the balance sheet.
As such, those on the buy side that value those services—which, as it turns out, is the majority—were forced to concentrate most of their trading with a smaller number of brokers. Case in point: In 2017, U.S. investors allocated 51% of their IRS trading with their top three dealers; in 2018, that percentage grew to 60%. Doing so all but ensures those clients trade enough with their top brokers to get top-notch service in return.
Trading and Clearing Remain Separate
While 3 of the top 4 largest dealers trading IRS with the buy side are also the three largest swaps clearing firms, the businesses remain separate and distinct. Citi, for instance, who ranks top in both categories using volume-weighted market share as a metric for the first and customer funds held as a metric for the second, operates a very large prime brokerage business for which swaps clearing is a logical component. By contrast, Goldman Sachs, also a top-tier swaps dealer by volume, is only the sixth largest clearer, given the firm’s historical focus on trading and somewhat smaller rates prime brokerage business.
So while regulators put in place rules to keep these businesses separate in hopes of reducing pricing power for the largest firms, ultimately the different risk profiles of the two business lines do not impact one another. The roughly one-third of IRS that remains uncleared somewhat contradicts this idea. However, the reporting of those trades and uncleared margin requirements have dampened systemic risk considerably.
It should also be noted that the same rules that make swaps clearing a bad business for all but the largest scale dealers are the rules that ensure those large providers of swaps clearing reduce rather than inject risk into the system. The supplementary leverage ratio (SLR) requires banks to hold more capital as their clients’ positions grow—a perverse disincentive from encouraging more clearing that limits the ability of the swaps clearing business to grow. Changes to these rules are in the works, however, and should result in keeping risk low while encouraging more clearing—a policy goal the world over since the 2008 financial crisis.
Lastly, it is important to note that the legislation designed to reduce systemic risk in the banking system has largely been effective. The Tier 1 capital ratio of U.S. banks is now 9.77, up from 7.45 at the height of the crisis. Uncleared margin rules that are continuing to capture a wider portion of the market are also bringing more into clearinghouses, a net positive for systemic risk. Thinking specifically about complex OTC derivatives, the value of Level 3 assets held by banks, which are penalized with high capital costs that have driven the move toward simplification and clearing, is down 85% since 2008 to a mere $30 billion.
Service and Pricing, Not Technology, Differentiate
We believe the current system does not pose immediate systemic risk, and the fact that the largest banks continue to dominate should not be cause for alarm. However, there are a few points worth considering as we move forward. Investors must ensure that their ability to quickly transfer positions from one clearing broker to another remains intact. While we hope the Lehman default was a once-in-a-career event for all of us, in the unlikely event of a bank failure—even one unrelated to the swaps business—being able to move positions quickly to one or several of the others remaining is critical.
Ultimately, trading and clearing business goes to those that provide the best service, market color and tightest pricing. Our several hundred interviews with buy-side swaps traders in the U.S. and Europe reinforce that fact. The swaps market should not rest on its post-Dodd-Frank laurels but should continue to look for ways to improve. The myriad rules that oversee the swaps market should not only create a safe market but also encourage healthy competition.Methodology
In the first half of 2018, Greenwich Associates conducted interviews with 85 interest-rate derivatives investors in the United States as part of its annual North American Fixed-Income Investors Study.