10 November 2011

ISDA publishes discussion paper on costs and benefits of mandatory electronic execution requirements for interest rate products

The International Swaps and Derivatives Association (ISDA) announced the publication of an in-depth discussion and analysis of the impact of electronic execution requirements on over-the-counter (OTC) derivatives markets that were mandated by the Dodd-Frank Act.

The paper, “Costs and Benefits of Mandatory Electronic Execution Requirements for Interest Rate Products”, was developed by ISDA staff and consultants in conjunction with NERA Economic Consulting, which assisted with research and analysis.

The paper explores and analyses whether the market structure being developed by the Commodity Futures Trading Commission (CFTC) to implement these requirements will meet the CFTC’s key goals:  increase the efficiency of the market by reducing transaction costs, improving access to markets and increasing transparency. The paper also assesses the costs and expenses that market participants and ultimately end-users are likely to bear as a result of the mandate’s implementation.

The paper finds that:

• OTC derivatives pricing is extremely competitive, compares favourably to similar futures products and, unlike futures execution, is available in large transactions.
• The electronic execution mandate and the proposed new regulatory framework will limit choice for end-users and ultimately increase transaction costs. 
• The possible benefits for small end-users will be no more than $1,000 for a $10 million interest rate swap before fees for execution and clearing. Any net benefit for small end-users will be dramatically outweighed by costs to the market as a whole.
• Estimated initial set-up costs to market participants from the new rules are more than $750 million, while ongoing costs are more than $250 million per annum.

The initial and ongoing costs identified in the paper amount to approximately $1,300 per transaction. These costs, of course, do not currently exist in the marketplace.

Derivatives users believe restrictive provisions in the proposed rules such as the 15 second rule, the requirement for at least five participants to quote through a request for quote (“RFQ”) platform, very high block trade thresholds and very short block trade reporting delays will negatively impact liquidity and push transaction costs up further.

“Our research and analysis indicate that the electronic execution mandate will result in higher bid-offer spreads and significant costs, most of which will be borne by end users”, said Conrad Voldstad, ISDA Chief Executive Officer. “There is little to suggest that it may benefit any market participants. There is, to the contrary, much to suggest that it will take away users’ choice, create inefficiencies and discourage innovation.”

Mr Voldstad also noted that the mandate for electronic execution is not related to safety or soundness issues, which are properly covered in rules regarding clearing and reporting of transaction data to regulators. It is instead a market structure issue that should be justified by rigorous cost-benefit analysis as required by law. Toward that end, ISDA decided to conduct a comprehensive study of the relevant issues. The study indicates that the mandate will, in all likelihood, bring little or no benefit to the market while adding significantly to the costs of using derivatives for end-users.

Full discussion paper

© ISDA - International Swaps and Derivatives Association