WASHINGTON — Several derivatives market participants attending a federal roundtable here were supportive of a lag in the reporting of large or “block” over-the-counter derivative transactions that can move the market, but they were not sure how much of a delay would be reasonable.
Panelists were also unsure how to precisely define a block trade, except that it should be based on the point at which a trade is so large it moves its respective market.
The roundtable, sponsored jointly by the Commodity Futures Trading Commission and the Securities and Exchange Commission, Tuesday focused on provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act that are designed to increase the transparency of pricing in the OTC swaps market. The CFTC must implement rules for swap dealers that serve as counterparties to municipal swaps by next July, one year after the law’s enactment.
“Detailed disclosure is important. The only question is how much of a reasonable delay do you want to have,” said Peter Shapiro, managing director of Swap Financial Group in South Orange, N.J., and a participant in the roundtable.
Shapiro drew agreement from other panelists by warning that end-users such as municipal borrowers may face increased costs if their dealer counterparties are required to report, in real time, that they have entered into large, relatively illiquid swap agreements, such as those based on the Securities Industry and Financial Markets Association’s swap index. The index is the predominant index used for swaps entered into by municipalities and is significantly less liquid than those based on the London Interbank Offered Rate.
As a result, it may be harder and more costly for dealers to enter into simultaneous or subsequent transactions that hedge the risks they take on as counterparties based on the SIFMA index or highly tailored derivatives — costs that they may have to pass onto issuers.
Shapiro stressed that the trades should all be disclosed eventually, but the dealer should be given up to several days to quietly line up its offsetting hedges without alerting hedge funds or banks that could engage in front-running and make the transactions more expensive. He proposed that the lag be based on the average daily trading volume of the type and maturity of swap.
For instance, if there are normally about $200 million of SIFMA index-based interest-rate swaps traded in a given day, then a dealer that has just entered into a $1 billion SIFMA index-based swap should have five days to hedge the transaction before publicly reporting the trade.
However, Shapiro said it may initially be difficult to measure with much certainty the market volume of a particular type of derivative, since derivatives are not currently regulated at all.
But Michael Masters, president of Masters Capital Management who was representing Better Markets Inc. on the roundtable, warned that while he understood Shapiro’s concerns about front-running in the market, any reporting delay “needs to be pretty quick because the public suffers the longer the delay.”
“I’d argue it needs to be quicker rather than later,” Masters said.
Chester Spatt, a professor of finance at Carnegie Mellon University’s Tepper School of Business, said he is skeptical about regulators’ agreeing to a delay without any empirical evidence that end-users will actually be harmed if their counterparties must report trades with them in real time.
Spatt warned that the industry repeatedly raised concerns that the development of the Financial Industry Regulatory Authority’s TRACE system for corporate bond transactions would decrease liquidity but said they never presented actual evidence.
The municipal market, Spatt said, is the only over-the-counter market he knows of in which retail investors are routinely “hosed,” because spreads are wider on smaller transactions than larger ones.
Yunho Song, managing director and senior trader at Bank of America Merrill Lynch, stressed that there should not be a complete carve out of block trades, but suggested that regulators consider requiring more plain vanilla block trades to be reported initially and more exotic block trades at a later date, mirroring a tiered system FINRA adopted in rolling out TRACE.