The Federal Reserve Bank of New York is challenging concerns that proposed US rules requiring reporting of trading activity in credit default swaps on the day it occurs will affect market liquidity or dealers’ ability to hedge.
Dealers typically did not hedge large customer trades either on the same or next trading day, said a report released on Tuesday. This cast doubt on Wall Street concerns that a proposed US rule requiring the reporting of such information would have an impact on their ability to hedge.
“Our analysis seems to suggest that requiring same-day reporting of CDS trading activity may not significantly disrupt same-day hedging activity, since little such activity occurs in the same instrument,” said the authors.
But against the backdrop of proposed rules for reporting trades under the Dodd-Frank regulation, covering the financial services industry, the report said policymakers should be mindful of how markets will react in the future.
“It will be important for policymakers to gauge what impact greater post-trade transparency would have on dealers’ existing approach of holding on to risk and trading out of positions gradually, as our analysis suggests this behaviour is important in facilitating trading in the CDS market currently.”
The NY Fed found “little evidence that dealers regularly hedge large trades using offsetting transactions [on the same day of the trade]”.
“The reason hedging does not take place in the identical instrument [immediately] is because it is not always available,” said Athanassios Diplas, global head of systemic risk management at Deutsche Bank and co-chairman of a swaps-industry governance committee and transparency working group. “To the extent that the information [on large transactions] is released too early, it could still affect liquidity and therefore trading costs for clients.”
The proposal, put forward last year by the Commodity Futures Trading Commission as part of the Dodd-Frank financial overhaul law, has been attacked by trade groups and large financial companies for proposing near real-time reporting of large swaps trades. In numerous comment letters filed with the commission, dealers claimed the proposed rules would harm liquidity and pricing.
Dealers argue that they need time to hedge large customer trades and that any leakage of information will impair their ability to provide liquidity for the market, raising the spectre of higher trading costs for clients.
But not all dealers are against same-day reporting. Sonali Das Theisen, director of credit trading at Barclays Capital, said it was “valid for most actively-traded instruments, but might be an issue for the less liquid instruments. There is no issue with real-time reporting of non-block trades. The question here is what is considered block and how do you define a block.”
She added: “If a dealer only has the opportunity to hedge the risk of a block trade one week after execution, reporting the trade information to the market at the end of the day might disincentivise a dealer to do those transactions in the first place because hedging the position would become too expensive.”
The NY Fed paper noted dealers’ concerns that market participants might seek to front-run – take advantage of the knowledge of a pending transaction – in their attempts to offset customer trades, in turn increasing the cost of hedging.
The authors said they looked only at a specific type of hedge – offsetting CDS trades in the same entity – but their findings corroborated “anecdotal evidence that dealers typically trade out of positions over a number of days or weeks”.
The study comes at a critical time for the derivatives industry in its attempts to dilute rules that are being backed by Gary Gensler, CFTC chairman, in an attempt to improve the transparency of pricing for swaps soon after the trades occur.
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