Public pricing of U.S. derivatives nears, threatening bank dominance
NEW YORK Nov 21 (Reuters) - The prices paid for trades in the U.S. derivatives market will soon be made public, a dramatic change that may accelerate the shift of market power away from a few dominant financial market players and shed some light on a traditionally opaque market.
Price transparency is key to the Dodd-Frank reforms of U.S. financial regulation in 2010 in the derivatives market, where in some cases prices of actual trades are difficult to verify. Opaque pricing has made valuing derivatives more difficult and in some cases has fed panic in markets over the health of companies.
The opaque structure of trading has worked to the advantage of the large dealers that dominate the market by allowing them to profit from wider spreads between prices paid and received.
Some large fund managers have also benefited from more favorable pricing and the ability to game price differences between the banks.
That may be about to change. Companies that collect trade data will soon be required to make the price information public.
"It will improve competitiveness and lower search costs for market participants and it will reduce the oligopolistic power of the largest dealers," said Darrell Duffie, a finance professor at Stanford University.
Chief U.S. derivatives regulator, the Commodity Futures Trading Commission (CFTC), on Tuesday extended the deadline for reporting until April 10, at the latest.
The information will be closely observed, and will allow smaller participants to test the quotes they receive against other investors' trades.
It may also make banks more reluctant to quote more favorable prices to larger clients, for fear that others will demand the same treatment.
"It's going to keep people much more careful on what they price," said Peter Tchir, founder of financial advisory firm TF Market Advisors, and a former credit derivative trader.
As the financial crisis in 2008 was starting, news of rising costs to insure debt in companies like Bear Stearns and Lehman Brothers against default helped feed a negative feedback loop. Investors, frightened at the prospect of default, took bearish options positions and started selling bonds and shares of stock. As those prices plunged, the panic increased.
"I think it's healthier for the market in the long run, it's one more step toward having a much more electronic trading environment in fixed income," Tchir said.
THE BOND EXPERIENCE
At least initially, some warn that the shift may add some market volatility and make it harder to execute large trades.
Some large fund managers have argued that price transparency may hurt their ability to execute trades if it reveals their trading strategy, or identity. Dealers also say it could make it difficult for them to hedge positions made for clients.
Prices will have to be made public with delays that vary by contract, but those time delays will shrink after the first year, per the requirements of the CFTC.
Public data will show the contract type, duration, price and notional size, and the information will be available for download.
However, the experience of the corporate bond market, which adapted to new transparency rules after the Trade Reporting and Compliance Engine (TRACE) system was introduced in 2002, suggests that fears over liquidity may be overstated.
"Liquidity was not harmed," said Michael Goldstein, professor of finance at Babson College in Massachusetts, who published a widely referenced report on the effect of TRACE on the corporate bond market with colleagues in 2007.
"I suspect it will be comparable" for derivatives, he said.
For bonds, new transparency also helped reduce trading costs in the market.
"Spreads went down pretty soon (after its introduction), and there was evidence that the effects got even stronger over time," Goldstein said.
Some confusion in the market relating to which swaps are eligible, however, may restrict the amount of trade data ultimately made public.
Dealers are grappling with which entities and trades are covered under other rules meant to reduce the risks of overseas trading harming U.S. companies.
"Without any clarity on the cross-border issues, it's still unclear as to which swaps are going to have to be reported," said Evan Koster, a partner at law firm Hogan Lovells in New York.
Some also fear that technological issues relating to how banks route information to swaps data repositories could also cause delays.
Representatives of swaps data repositories, however, say they are ready to provide live prices.
Marisol Collazo, managing director of the trade information warehouse and global trade repository services at the Depository Trust & Clearing Corporation, said the company is ready to provide continuous price streams by asset class and product and will offer RSS feeds on its Web site.
Bruce Tupper, president at ICE Trade Vault, part of IntercontinentalExchange in Atlanta, said ICE is also ready to distribute the data in real time and apply filters for each required price delay and to anonymise trading partners.
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