Thursday, January 31, 2019 Stamford, CT USA — Regulators are batting .500 when it comes to their dual goals with post-crisis reforms in the U.S. interest-rate swaps (IRS) market: making markets safer and encouraging competition in swaps trading and clearing. 

A new report from Greenwich Associates shows that regulations implemented after the Global Financial Crisis have reduced both systemic risk and competition. “In fact, the very rules that have made this market safer and more stable have made it much harder for new competitors to enter the market,” says Kevin McPartland, Head of Research for Market Structure and Technology at Greenwich Associates and author of Top Dealers Continue to Dominate Swaps Business.

More Concentration…

The U.S. IRS market became more concentrated when swaps clearing and trading rules were put in place under Dodd-Frank. By Q2 2018, the top five swaps dealers were handling 63% of buy-side trading volume, and the top five clearing brokers held 75% of customer margin. (More recently, Greenwich Associates analysis shows that concentration also started to increase in Europe as MiFID II rules were finalized and implemented.)

The primary factor discouraging new competitors from entering the fray is the capital intensity of the business. “Equity, FX, U.S. Treasury, and corporate bond markets have seen an influx of new liquidity providers,” says Kevin McPartland. “In the swaps market, the new entrants that are still standing can be counted on one hand.”

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. As such, those on the buy side were forced to concentrate most of their trading with a smaller number of brokers. Case in point: In 2017, U.S. investors traded 51% of their IRS volume with their top three dealers; in 2018, that percentage grew to 60%. 

Less Risk

The same rules that make swaps clearing a bad business for all but the largest scale dealers are also ensuring that 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. Meanwhile, other 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. 

The report concludes that 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, we applaud ongoing efforts to encourage competition,” says Kevin McPartland. “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—the ability to have other options and move positions quickly from one clearing broker to another is critical.”