Putting the Market Back Together: TABB Group's Kevin McPartland

Three years after the last financial crisis, the Dodd–Frank Wall Street Reform and Consumer Protection Act remains a semblance of the bill it was outlined to be. But Congress, in cooperation with the United States' largest financial institutions, is nearing a policy consensus that will strengthen the bill's regulatory ability considerably.
Kevin McPartland, director of fixed income research at the financial markets and advisory firm TABB Group, is a true insider with regard to Dodd-Frank's development. McPartland has testified before the Senate Banking Committee and is well known in and outside of Washington for his expertise on the derivatives market.
In this episode of Attention, Benzinga Radio picks McPartland's brain on the evolution of Dodd-Frank: we discuss the tone of current relations between the institutions and Congress, how the bill's provisions will change the $600 trillion notional value derivatives sector, and conclude with an outlook on US debt in the wake of the debt ceiling debate. Partial transcript below. On new Dodd-Frank rules for OTC derivatives:

- "One way to look at [the swap execution facility] is that it's somewhere of an in-between of a futures exchange or a stock exchange and the OTC markets that we have today." - "[The swap execution facility] will ultimately allow buyers and sellers to be matched up like an exchange, but it will allow the OTC market to continue to function--just with a little more automation in the middle." - "There is a difference between trading and clearing; you can have one without the other… In the past, if bank A did a credit default swap with hedge fund B, they would be exposed to each other. With a clearing house, bank A is then selling to the clearing house, and the clearing house basically then is selling to the hedge fund. Both of those original two counterparties only face the clearing house." - "The clearing house is designed in such a way that it almost completely mitigates the risk of holding those positions, because really, that's what it's there for." - "Not all swaps will be forced into clearing houses, but there is a requirement that all OTC derivatives transactions--all swaps--will have to be reported to the swap data repository. That exists to some extent now, but that will be expanded. That, in and of itself, should provide a lot of transparency." - "I think one of the big impacts of [higher capital requirements] is initial margin. When two big banks--or a big bank and an asset manager--do a swap today, there is rarely any initial margin posted, which is the opposite of when you're trading on a futures exchange, where maybe you will put up 3% or 5% of the value of the future to put that trade on. That's not the case today in most of the swaps market." - "When we move to a clearing environment, [initial margin] will be an important element--you will have to put up a portion of the trade. It might not seem like a big deal if we're talking about 2% or 3% of the value, but when we look at the interest rate swap market, where the average trade size is roughly $125M, 2-3% is a lot of money."

On pushback from the banks over regulatory changes:

- "The banks are understanding that this is coming. I think everybody has accepted that these changes are here to stay and we're not going to go back to the way we were before." - "Everybody is working to put the market together in a way that it can still function well. There is some proposed regulation that maybe would hurt liquidity instead of improve it." - "There still is a lot of discussion and debate going on as to these last final details to ensure that what is put in place is not just the best political endgame, but is actually the best endgame for the market, liquidity, and its usability, really."

On how effective Dodd-Frank will be in resolving the issues (with respect to derivatives) that arose during the 2008 financial crisis:

- "It's a really great question. I think there are pieces that will directly go back to the financial crisis, and there are other pieces that maybe really weren't needed as an answer to the financial crisis." - "I think central clearing, by its nature, will help to mitigate risk. It doesn't completely eliminate the risk from the system, but it does severely mitigate the risk of the interconnectedness that really was at the heart of the financial crisis, between all of the big banks." - "Yes, clearing houses do become--you could call them the next TBTF, SIFI, whatever term you want to use. The big difference here is that banks are largely designed to take risk; that is what they do. Clearing houses are designed to limit risk as much as possible. Yes, they will become very, very important to the health of the financial system, but their only goal is to reduce risk. I think that's a positive advancement." - "I've spent a lot of time looking at swap execution facilities and the swap execution space. However, I'm not completely convinced, at this point, that we really needed to mandate electronic trading of swaps. I think if clearing and reporting requirements were in place, that kind of trading transparency would have arose naturally."

On high-frequency trading in swaps markets:

- "We're not going to see the kind of micro-second level trading that we see in the equity markets today in swaps, but there is little debate that the frequency of trading in the swaps market will increase significantly from where it is today." - "There are a lot of new opportunities, both as these guys coming in as market makers and helping add liquidity to the market, but then over time, there is also a lot of basis trading and relative value trading that could go on where you're looking at the price of the swap as it compares with the related futures contracts." - "That's a good thing in the long run, because it will ensure that prices of related assets remain very, very tight with one another."

On concentrating risk to the clearing houses:

- "If you stand back and look at it from the outside, concentrating all of that risk to the clearing houses seems very scary. If you dig in to how they operate, how they manage that risk, the amount of capital that they hold, the margin they collect on every trade--the risk isn't as great as it seems from the outside." - "One paradox is that we've seen a lot of negative talk about high frequency trading in other markets, blaming it for the flash crash and a variety of other things. Now we're in a place where the regulators and Congress are putting in place laws and rules that will, in fact, incentivize more electronic and higher-fee trading in these markets."

On whether Congress is asking the right questions with regard to the regulatory process:

- "They are. I do believe that--of the congressional staff that I've had the pleasure to speak with, and members of the regulators--they are working hard, they want to understand this, they want to get it right. Politics does get in the way sometimes, but I do believe they really are trying to get this right." - "Everyone in the U.S.--the regulators and the legislators--they want to keep the business here. They appreciate that this is an important part of the U.S. economy, and they want to ensure not only that it stays, but that it works more efficiently in the future." - "Any talk of crazy bans on things--I don't think that will come to pass because cooler heads will ultimately prevail in the end."

On the sheer size of the derivatives market:

- "The outstanding notional number that's often quoted isn't always the best metric. The actual money at risk is a good amount lower than that. It makes it sound a lot scarier than it is." - "I've had a lot of conversations with the big dealers over the last two or three weeks. There seems to be some consensus that using that metric--the outstanding notional--the market will grow slightly, but it will be slow as time goes forward because some of these new mechanisms like clearing will help to net some of those trades out so that those numbers aren't as big." - "If you look at the futures market, each year, in the U.S., it turns over about 25x its value. The numbers are in the quadrillions of dollars traded. If you look at the OTC derivatives market, that number is only about 3. So even if we move from 3x turnover to 4x or 5x, that's a tremendous amount of more money that's going to go through the system. That seems pretty likely in the next 3-5 years."

On the difference between interest rate swaps and credit derivatives:

- "Some might argue that the products are different, so the rules should be different. The reality is that the market dynamics are close enough to where the regulators should put similar rules in place and then let the marketplace deal with those differences."

On what he wants to know more about:

- "This is the question that everyone asks and nobody has the answer to: When will we have some clarity on what the rules of the game will be? At this point, most everybody just wants to know what the rules are and what the timeline is so they can get ready." - "The negative of all of this is that it brings a lot of complexity. The transparency, the systemic risk reduction, the clearing houses, etc. That's good for all of the reasons we discussed, but understanding all of these hundreds and hundreds of pages of new rules, and the ways that it works, is really complicated. There is some risk that these new complications can cause their own backlash, if you will." - "The interconnectedness caused the problem in the bilateral swaps market, as it's been in the past, but it was relatively straightforward--if you wanted to do a swap, you call a bank, you arrange the contract, and it's done. Now, there is going to be a whole plethora of compliance requirements around it. They're all intended to make the system operate more smoothly, but again, we can't ignore that there is going to be hundreds and hundreds of pages of rules that everyone is going to need to understand to ensure this works properly."

On the debt ceiling debate:

- "The market isn't really pricing in a technical default or a downgrade at all, but again, politics is a whole different beast. The rules of the game and the goals in Washington are a lot different than they are in New York and the other financial capitals of the world." - "If I had to, I would say that the night of the deadline--at 2:00 in the morning--is when they will come back with a resolution."

On the status of U.S. Treasuries as a risk-free investment:

- "I think it is. We know that any default is a technical default. Of course, the U.S. is going to make good. If they are late on a payment by a day, then technically, that's a default, but you're still going to get your money back. The U.S. government will make money when they need to make money, so I think it's still a safe bet."

On increased demand for Treasuries going forward due to higher capital requirements and new collateral rules:

- "If everybody is going to start selling because they are worried about a U.S. default, [there will be] huge demand for cash assets--Treasuries and other similar government securities." - "If we look at what the new potential collateral margin requirements are going to be in the OTC derivatives space, our estimates put the worst case scenario at an additional $2T in collateral. It's probably not going to be that high, but even if we're a little over $1T, that's a lot of money, and it needs to come from somewhere… That's going to drive demand for Treasuries." - "I just can't see how we're going to have a long-term negative move."