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With Volcker, much of the discussion and trepidation relates to the market-making exemption; but the biggest changes may actually be in hedging. And the technology to support tagging of trades into specific exemptions and the monitoring for violations may be immature, if it exists at all. Without technology, trading under Volcker becomes a manual nightmare.
Clearing of derivatives trades is nothing new either, of course; but making it mandatory for a wide range of participants in Europe is new. The increased cost of margin is well documented, and has prompted some buy-side firms to move from swaps to futures, which has further prompted some FCMs to exit the swaps space; but the concentration of risk in the CCPs is only now coming to front-of-mind. Once that concentration is well understood, and the sources of CCP capital become clear, there will be a scramble to enhance the regulation of that sector, leading perhaps to more exits from the business … leading to even more concentration of risk … leading perhaps to even more regulation.
As spreads have fallen in every market, trading firms have predictably moved away from manual, expensive trading methods toward automated ones. Every month the percentage of computer-executed trades has been rising, so that by year-end half or less of the trading decisions in just about every market will be made by people. In fact, we even have the science-fiction scenario of buy-side bots trading with sell-side bots.
The biggest risk with automated trading is that most of the algorithms are mean-reversion formulas, meaning that the right price for anything is a function of the price of everything else. Experienced traders know that that kind of pricing works well when markets are essentially stable, but breaks down when large secular shifts occur. Looking at 2015, one such secular shift would be the end of the Fed’s many years of easing, and another would be a resumption of the financial crisis in Europe. Perhaps both of them at the same time.
All this means that the risk in the markets will probably be higher in 2015 than it was this year. One simple measure might be in the potential mark-to-market for the largest category of swaps, fixed-float rate swaps. If we assume $420 trillion outstanding notional, 75% of it back-to-back, with an average tenor of six years, the mark-to-market of just the net exposure for a 100 basis-point rise in rates is $5.5 trillion. Given that such a rate rise would also serve to depress the market value of the very Treasuries used to generate the margin, we can see that there could be a tsunami lurking just under the surface of the markets.
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