In the wake of the recent Global Crisis, the G20 leaders resolved at their 2009 Pittsburgh Summit to reform global derivatives markets. A key ingredient of these reforms has been to take contracts previously traded in opaque, decentralised, over-the-counter (OTC) markets and to force them to be traded in more transparent exchange-like settings, also known as swap execution facilities (SEFs). The aim has been to ensure that information on prices is available more widely, to reduce the cost of trading in these instruments and to make markets more resilient in turbulent periods.
SEFs render the trading landscape more centralised and transparent in two ways. First, they are required by law to feature an electronic order book. This, in principle, allows end-users to trade directly with each other by posting their own quotes. However, given the relatively small number of participants and trades in swap markets, activity on these order books may take some time to pick up. Second, and most importantly, SEFs also change the rules of dealer intermediation. If you are an end-user who wishes to trade a swap contract and you submit a request for a price quote through the SEF, this request is now automatically disseminated to at least three dealers of your choosing. The dealers then respond with their quoted prices and you can simply trade against the best offered price. SEFs thus represent a step increase in pre-trade transparency as they drastically reduce search costs and promote competition among dealers. Figure 1 illustrates this change in swap trading brought about by SEFs.
Figure 1. Post Dodd-Frank, swap trading for mandated contracts must be done on an SEF
SEFs allow market end-users (EU) such as asset managers (AM) and hedge funds (HF) to directly trade with each other. Additionally, should market end-users wish to trade with a dealer (D), they can do so in a way that enables them to compare quoted prices across a number of different dealers.
The US implemented the derivatives reforms as part of the Dodd-Frank Act. In particular, the trade mandate was implemented in two phases: first, the CFTC authorised SEFs in October 2013; and second, in February 2014 it mandated that specific contracts be traded exclusively on SEFs by ‘US persons’. In the next few years we will see legislation come into force in the EU, as part of MiFID 2, which mandates similar trading arrangements in Europe.
This is a textbook case of a step increase in pre-trade transparency and the natural question is whether the intuition in Duffie et al. (2005) that “bid-ask spreads are lower if investors can more easily find other investors or have easier access to multiple market makers” has empirical validity in one of the world’s largest financial markets.
In new research, we analyse the impact of the Dodd-Frank trade mandate on the market for plain vanilla interest rate swaps (Benos et al. 2016). We ask whether the move to centralised and more transparent trading has made swap markets cheaper and easier to trade in. Our work complements existing studies on other aspects of the derivatives reforms such as centralised clearing (Loon and Zhong 2014) and post-trade transaction reporting (e.g. Loon and Zhong 2015, Fulop and Lescourret 2015)
The empirical strategy
We exploit the fact that the obligation to trade on an SEF has, thus far, only been made compulsory for persons from the US and only for a subset of interest rate swap contracts. Any trade in this subset of contracts that involves a US person must take place on a SEF. Trades between non-US persons or trades in non-mandated swaps do not need to be completed on an SEF.
Our empirical framework uses these differences in trading rules for different contracts and counter-parties to isolate the effects of SEF usage on swap market liquidity. We employ proprietary swap execution data from the London Clearing House and public swap trading information from the DTCC in the US. We construct a treated sample, consisting of trades in mandated US dollar swaps (that are traded in the main by US persons) along with two control samples. The first control sample is a set of trades in non-mandated US dollar swap contracts while the second control sample consists of trades in mandated euro swap contracts which are mainly traded by non-US persons. This implies that for euro-denominated contracts, SEF penetration is lower (Figure 2). By comparing the level of transactions costs or trading volumes in the treated and control samples, we can draw inference as to the effect of the introduction of SEFs on swap market liquidity.
Figure 2. Fraction of SEF trading for US dollar and euro denominated plain vanilla interest rate swap contracts
The fraction of SEF trading is the volume executed on a SEF divided by the total traded volume in that currency.
Our core result is that the introduction of SEF trading is associated with a significant improvement in swap market liquidity. In raw cash terms, the incremental reduction in trading costs for US dollar mandated swaps (the treated group), relative to dollar non-mandated and euro mandated contracts (the control groups) is around $2-4 million daily. And the total reduction in execution costs for dollar mandated contracts is in the range of $7-13 million daily. Clearly, the improvements in liquidity were greatest where SEF trading was most heavily used. Thus, more centralised and transparent trading is associated with more liquid markets, precisely in line with the intentions of the legislators.
We also investigate how these new regulations changed trading patterns in swap markets. We find that following the implementation of the trade mandate, the euro-denominated segment of the interest rate swap market became geographically fragmented whereas the dollar-denominated segment did not. European and US traders tended to trade less euro-denominated contracts with one another and more within their own geographical group. Figure 3 illustrates this.
Figure 3. Fraction of interest rate swap trades conducted between US and non-US counterparties, for dollar and euro-denominated swaps
However, the observed fragmentation of the euro segment is almost entirely driven by inter-dealer activity (Figure 4). Given that overall inter-dealer trading did not change as much, this suggests that some dealers may have sought to avoid being captured by the mandate and/or the accompanying requirement for impartial access on SEFs as outlined in CFTC (2013).
Figure 4. Breakdown of the US to non-US fraction of trading in euro-denominated interest rate swap contracts between interdealer and all other trading activity
Increased transparency and centralised trading improves swap market liquidity. It makes it easier for investors to see where the market is trading and erodes the market power that swap dealers possessed when trading was OTC. These results chime with theoretical predictions and empirical findings from a variety of different markets such as equities and corporate bonds.
While we have shown that centralised swap trading has been beneficial in terms of improved liquidity in relatively normal periods, we have not been able to see how these markets operate in more volatile times. It will be important to assess how these markets function in periods of stress as one rationale for their introduction was that opacity feeds market instability.
We might extrapolate our results to consider what might happen in Europe if centralised swap trading was to be mandated there as part of MiFID 2. We would expect improved liquidity just as we have seen in the US (and for the same reasons). We would also expect the geographical fragmentation of markets to be reduced or eliminated as regulation is harmonised.
Benos E, R Payne and M Vasios (2016) “Centralised trading, transparency and interest rate swap market liquidity: Evidence from the implementation of the Dodd-Frank Act”, Bank of England, Staff Working Paper No 580.
CFTC (2013) Guidance on application of certain commission regulations to swap execution facilities, November.
Duffie, D, N Garleanu and L H Pedersen (2005) “Over-the-counter markets”, Econometrica, 73(6): 1815-1847.
Fulop, A and L Lescourret (2015) “Transparency regime initiatives and liquidity in the CDS market”, working paper.
Loon Y C and Z K Zhong (2014) “The impact of central clearing on counterparty risk, liquidity and trading: Evidence from the credit default swap market”, Journal of Financial Economics, 112(1): 91-115.
Loon Y C and Z K Zhong (2015) “Does Dodd-Frank affect OTC transaction costs and liquidity? Evidence from real-time CDS trade reports”, forthcoming, Journal of Financial Economics.