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Paul Rowady

TABB Group

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Paul Rowady

10 May 2011

Interest Rate Derivatives 2011: Collateral Damage in the Duration Market

Executive Summary
Take the largest derivatives market on the face of the planet, place it in one of the most complex and turbulent economic times in modern capital markets history, and then try to change a bunch of the rules in the space of a couple years.  What might normally sound like a cruel joke, or a fool’s errand, is exactly where we find ourselves today.


Given that this is the scene playing out in the mammoth interest rate derivatives markets, TABB Group took the pulse of rates market players before the full wave of new rules hits landfall in the coming months – and years.  For sure, we are in the early innings of this transformation, and therefore, this story has a long way to go.  But, what we wanted to know today is:  Have these players begun to prepare?  Is there a sense of urgency?  And, how are they operating now in the face of such uncertainty?


What we found was worthy of the journey.


For starters, most players are, at best, under-prepared and at worst, indifferent.  Apparently, status quo behavior is cozy and familiar, and inherent uncertainty in the regulatory process is a convenient excuse for inaction.  But in the face of such dramatic transformation this tack is ultimately a recipe for volatility.  After all, we’ve seen far too many hurricanes, floods, earthquakes, tornadoes and tsunamis wash away the best-laid plans these past few years.  Fortunately, standards, trade automation and clearing are taking hold among major dealers, and the first moves on the client side have already begun to play out.  Plus, new players are eagerly waiting in the wings.


The bottom line, however, is that new collateral rules are aimed at the jugular: the balance sheet.  Going forward, capital efficiency via portfolio margining innovations may end up being the best defense against the current onslaught.  Flanked on one side by impending collateral impacts of Dodd-Frank legislation and new leverage-limiting rules being negotiated under Basel III on another, balance sheet management will become important in ways that we have never contemplated.  Here, too, we are only in the early stages of the story.


The regulatory timelines are still up in the air, yes, but that doesn’t mean that rates players shouldn’t begin preparing now for an era of more collateral costs and intrusive reporting requests.  In other words, if you want to continue to play in these markets—particularly in swaps and exotic instruments—you had best learn how to navigate more balance sheet pressure and more intrusive reporting requests. 


The silver lining to all this—and there definitely is one—is that market structure will evolve more slowly than the DC saber-rattling would lead us to believe, and eventually evolve for the better.  The potential uptick in data fluency will be synonymous with better trade ideas and enhanced risk controls for those who stay proactive during these opportunistically unprecedented times.


Interest Rate Derivatives 2011: Collateral Damage in the Duration Market
This 55-page, 47-exhibit inaugural interest rate derivatives study is based upon discussions with 46 senior-level portfolio managers and traders on the buy-side and their counterparts on the sell-side who are responsible for OTC market making and fixed income-related offerings.  These discussions were conducted in January and February of 2011 and, with few exceptions, the respondents were based in the US.  The discussions covered trading styles, product usage, and expected impacts of ongoing financial regulatory reform.  Additionally, respondents were asked about preferred risk metrics, broker selection critieria, trends in trading platforms.

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