In the early days of the interest rate swap market, former Salomon Brothers trader Thomas Jasper remembers, transactions were recorded by hand. “When I was running the swap desk,” he says, “I used to carry my trading book in my breast pocket on one piece of paper.” It was only after the International Swaps & Derivatives Association, which Jasper helped found, created the standard swaps contract known as the master agreement in 1985 that the business began to grow exponentially.
While the master agreement helped bring some order to the market, swaps trading was still opaque. Deals were made over the phone and later by instant message—with no central recordkeeping. Uncertainty over which banks were tied to other banks and investors by swaps deals complicated efforts to respond to the 2008 financial crisis.
Now the $426 trillion interest rate swap business is stepping into the light. As of Feb. 15, the Commodity Futures Trading Commission requires most interest rate swaps to trade on systems known as swap execution facilities. On Feb. 26, contracts on indexes of credit default swaps became subject to the same regulation. The shift will allow investors to pit several dealers against one another to compete for the best price, a change from the practice of calling banks one at a time to ask what they were charging.
So far, 19 swaps execution facilities have received preliminary approval from the CFTC, including ICAP (IAP:LN), Tradeweb Markets, TeraExchange, TrueEX, and Bloomberg LP, parent of Bloomberg Businessweek. They are poised to take business from the big banks that have dominated swaps trading. Last year, JPMorgan Chase (JPM), the biggest U.S. derivatives dealer, said the new rules may cost it $1 billion to $2 billion in revenue a year. “People’s bonuses are tied up in that,” says Jasper. “This has been a very good business for the dealers for a very long time.”
The trading regulation, one of the most contentious parts of the 2010 Dodd-Frank act, is the final step in the four-year effort to create a market structure for interest rate swaps and other over-the-counter derivatives. Dodd-Frank provisions requiring that swaps trades be backed by a clearinghouse and that all trades be reported to central repositories took effect last year. Clearinghouses rely on their member banks to provide billions of dollars of cash and assets to hold in reserve in case of a default. They monitor prices and demand that parties holding money-losing positions put up additional cash.
With interest rate swaps, investors agree to make either fixed or floating payments to each other. As rates rise above the agreed-upon fixed level, floating payments increase, making money for the holder of the fixed-rate leg of the trade. Credit default swaps are a way for investors to bet on the financial health of companies and governments. The buyer of the contract pays a regular premium for protection against a borrower failing to pay its debt. CDS indexes track the prices of credit default swaps on a group of borrowers.
When Lehman Brothers declared bankruptcy in September 2008, the lack of market structure for swaps prevented regulators from knowing which financial institutions were at risk of failing next. The new rules will help avoid such situations, says Will Rhode, director of fixed-income research at Tabb Group, an advisory firm. “Any systemic issue with any one player going down is restricted to the fallout of that entity,” he says, “as opposed to a rippling cascade effect that threatens the global economy.”