Rule changes brought on by the Dodd-Frank Wall Street Reform Act are expected to produce the most change in the way trading in contracts involving interest-rate commitments.
But, for at least sell-side traders, technology is expected to produce at least as much change in the trading of interest-rate products. Which, in turn affects how corporations handle risk, since hedging dominates trading of those products.
Those are expectations elicited from conversations with 46 senior-level rates market participants conducted by Wall Street consulting firm Tabb Group. The firm spoke to senior-level fixed income-related portfolio managers and traders on the buy side; and executives and sales traders responsible for market-making and developing rates derivatives products on the sell side.
Forty nine percent of buy-side traders expected regulation to cause the greatest change, but only 29 percent expected technology to create the greatest change in what Tabb called “the largest risk transfer market in the world.’’
On the sell side, 50 percent of executives and traders said regulation would cause the most change. But 50 percent also said technology would cause the most change, putting it in a theoretical dead heat.
The importance of technology is not due to any “race to zero” speed in executing trades, like in stocks. Instead, “ in fixed income products you have a lot more structures that need to be put in; two, three, four, five, and six-legged trades,’’ as one “small-sized” asset manager put it.
“Automation can do wonderful things, but it still lacks the intelligence to respond to rates traders’ unique needs,’’ wrote the Tabb report’s author, E. Paul Rowady, Jr., a senior analyst. In trading of interest-rate derivatives, there is still “custom handiwork” done manually, even if manually now means phone calls, electronic mail or instant messages.
This is especially true in the swaps market, Rowady said, where only 12% of rates swaps are traded electronically, compared to 48% in the rates futures market.
The sell side has adopted electronic execution more quickly than the buy side, but a majority of both buy-side (89%) and sell-side (60%) rates traders believe that the best model for swaps execution is electronic.
A key set of provisions of the Dodd-Frank reform legislation calls for swaps of all kinds that can be standardized to be traded on electronic exchanges or, alternately, new venues called “swap execution facilities.”
Notably, the Tabb study found that only 40% of rates traders have begun actively preparing for reform measures.
The rest are monitoring progress of converting the legislation into formal marketplace rules. But the Securities and Exchange Commission and the Commodity Futures Trading Commission are both behind schedule in finalizing those rules.
The Tabb Group estimated the global trade in interest-rate derivatives at $665 trillion. This compares to trading in equities derivatives of $69 trillion.