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Kevin McPartland

Greenwich Associates

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Kevin McPartland

19 January 2012

Dealer with a Capital “D”

Answering the question of what is a dealer and whether to register as a Swaps Dealer.

Competition among swaps dealers young and old will be fierce, yet what constitutes a “dealer” still remains unclear. Defining dealer is important because those who register as Swaps Dealers will face tougher scrutiny — including more reporting and higher capital requirements — from regulators. And since the Commodity Futures Trading Commission recently passed a few rules relating to Swap Dealer registration, I thought it would be a good time to review the issues.

There are two sides to the debate over what a dealer is: the regulatory definition and the practical definition. The most pronounced regulatory definition comes from the CFTC. 

According to the CFTC, activities that make someone a Swaps Dealer are:

  1. Holding oneself out as a dealer in swaps or security-based swaps,
  2. Making a market in swaps or security-based swaps,
  3. Regularly entering into swaps or security-based swaps with counterparties as an ordinary course of business for one’s own account, or
  4. Engaging in activity causing oneself to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps.

Looking at this definition broadly, the most significant question is whether or not a firm that satisfies some, but not all, of these conditions should be required to register as a Swaps Dealer. Reporting, margin capital and other requirements for registered Swaps Dealers will likely be more onerous, so even firms that aspire to provide liquidity to clients will try to avoid the “capital S, capital D” label. It could be argued that being registered as a Swaps Dealer might act as an ironic competitive disadvantage. Principal Trading Groups (PTG), for example, fall into this bucket (see "Higher Frequency Swaps Trading: Market Making and Arbitrage," August 2011).

Activity No. 2 from the list above would lead you to believe that PTGs making markets in swaps must, in fact, register as dealers. The bulge-bracket global banks agree. If a PTG is making markets in 10-year interest rate swaps, shouldn’t they be forced to meet the same requirements that major banks have to meet?

TABB Group research has found that this is not the view taken by some regulators in Washington. The “dealer” title is intended for systemically important and highly interconnected firms that trade both cleared and non-cleared products. The CFTC proposal goes on to suggest that “dealers tend to be able to arrange customized terms for swaps or security-based swaps upon request, or to create new types of swaps or security-based swaps at the dealer’s own initiative.” None of those activities are, or likely ever will be, of interest to PTGs.

The story is different for banks and FCMs looking to get into the swaps market. In most cases, even if they could structure the business to avoid the Swap Dealer label doing so might not be such a good idea. More than 90 percent of participants in our U.S. Swaps Dealer study expect to register as Swaps Dealers, proof that even those who would prefer to avoid the additional regulatory oversight realize that registering is unavoidable and probably even necessary to grow in this business (see Exhibit). Whether rational or not, when clients are looking for a dealer to help with their swaps trading, they want a Dealer, not a Major Swaps Participant. Perception in this business is reality.

The more interesting debate is the practical definition of “swaps dealer.” As TABB Group sees it, there are four main roles that swaps dealers will need to fill going forward: executing (agency) broker, market maker, clearing broker and prime broker.

The first two roles describe what swaps dealers do today: Provide their clients with liquidity. In the new world, however, client facilitation and market making will likely be split in two, with the former helping clients find the liquidity they need on the appropriate SEF and the latter acting more as a standalone trading operation.

We’ve already established that PTG market makers shouldn’t have to register as Swap Dealers but what about an agency-only swaps dealer that offers client execution services but requires they clear elsewhere? In that vein, what about those firms that plan to offer clearing and custody services but not engage in active swaps trading?

As new rules hit the Federal Register in the coming months, these issues will start to become clearer. However, even when new regulations are final, identifying Swap Dealers from those simply looking for alpha with market making strategies will be complicated. The ultimate goal here should be to regulate systemically-important firms and ensure a more level playing field, not to place overly burdensome registration requirements on everyone looking to trade swaps.

Here’s to hoping.

Spotlight-white-trans For more stories in the OTC Derivatives Reform Spotlight Series click here.

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3 Comments to "Dealer with a Capital “D”":
  • Missing

    19 January 2012

    i have two opinions about the broker who starts subsidiaries to perform different functions.  MF global had 34 subsidiaries.  there is the issue of initial, and often separate, capitalization, corporate and subsidiary liability.  certainly clearing entails more risk and should not be able to use the same assets of the parent who is a broker.  you cannot double-count assets.

    but what happens if a clearing operation becomes bankrupt?  would the parent rescue it?  would this drag the parent into the bankruptcy?  and if not, why not?  if the parent enjoys the income from the subsidiary, should the parent be able to wall off liability if the subsidiary goes bankrupt?  if a subsidiary goes bankrupt,, should the parent also become bankrupt?  is the subsidiary joined like a marriage or separated like an ex-wife?

    then there's the question about bankruptcy.  brokers cannot go bankrupt, make any shares worthless, pay cents on the dollar to either customers or vendors and then resume business.  should a subsidiary be able to declare bankruptcy temporarily?

    and then what if, as is possible with mf global, the assets suddenly turn positive and pay off?  would there be a final distribution to the owners, if all bills are paid in full?

    personally, i am not in favor brokers becoming a one stop shop, forming subsidiaries to do several functions, but perhaps doing riskier things because they feel somewhat shielded from the consequences of their actions.  whether you like this bias, there is the question about whether a foreign-owned corporation can ship profits overseas but shield itself from the consequences of their actions because they have walled off the subsidiary from the parent.  this is exactly what is happening with interactive brokers.

    NASDAQ is an exchange but it is also clearing transactions.  if the clearinghouse fails, does this mean that NASDAQ fails?  what do you do with non-profits, if they fail?

    when i look at the market entities, i see subsidiaries assuming more risk because they have little to lose.  the parent may even direct business and set standards.

    maybe the answer is to disallow this walling off of entities and allow brokers to perform different functions but have separate capital to guarantee each function.  this would mean the parent is at risk for all functions, but if a department uses it's capital nest egg, they have to stop that function and the parent has to answer to the liability also.

    in my opinion, the regulators should decide about this and let the financial industry know, so that the financial firms know what is allowed and what is not and what the consequences are.  mf global, for instance, filed for chapter 11 (A chapter 11 debtor usually proposes a plan of reorganization to keep its business alive and pay creditors over time. People in business or individuals can also seek relief in chapter 11.).  but they are in liquidation because they were a broker.  any insurance should not be used to pay customers who have balances and the entity come out of bankruptcy and continue.

  • Anon_avatar

    19 January 2012

    It seems obvious that the bank-as-agent (i.e. the equity model)  model will eventually prevail. In order for this to occur, the cleared OTC swap market must truly be open to any and all who want to provide liquidity. I am not sure that the clearing model, with large swap dealers also acting as the clearing firms, provides for this.

  • Anon_avatar

    03 February 2012

    Has anyone looked into internalization of trading flow within a swap dealer that will be needed to have one desk in a particular product facing the street and streaming pricing when executing on SEFs? Some of the dealers today have multiple desks facing the street. Would going through a SEF require aggregation/centralization of trades internally?

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