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A Conversation with Citadel’s Paul Hamill
and Greenwich Associates’ Kevin McPartland

Five years after it was signed into law, the impact of Dodd-Frank continues to be a hot topic of debate in the derivatives market. To better understand the regulatory landscape and the state of the market, we spent ten minutes with two derivatives experts, Paul Hamill and Kevin McPartland. Here’s their snapshot view of where things stand – and where they’re headed.

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The question everyone wants to know – are markets better protected from risk than they were before the financial crisis?


 

Paul: Markets are far better off today. The Dodd-Frank Act requires swaps to be traded in fair, open markets with impartial access. Those requirements triggered a competitive dynamic allowing innovation and change to rapidly improve the market. In the old world, prices were opaque, dealing was manual and often over-complicated.


Today, institutional investors view and trade against firm pricing in real-time; bid-ask spreads are meaningfully tighter; execution certainty has been revolutionized; complex and expensive documentation has been eliminated; and systemic and operational risk have been substantially reduced.


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Kevin: Yes, the market has become a lot more aware of risk, and we’ve implemented reforms like clearing that, in hindsight, look obvious. But the next crisis always looks different than the last one. Since we don’t know what happens next, market participants must remain vigilant and the regulatory structure must continue to evolve to encourage competition and transparency.

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More than five years since Dodd-Frank was signed into law, the regulatory landscape remains the dominant topic of conversation among derivatives traders. What’s the latest – and what should investors expect looking ahead?


Kevin: There’s no question it’s going to continue to be a bumpy road, but it’s a net positive for investors. Smart and reasonable regulation adds efficiency to the marketplace, which over the long run reduces costs for investors. The insurance we get from an automated, open process is extremely valuable. Portfolio managers will also have more information and they will be able to make smarter choices.


Paul: I strongly agree. Try to imagine the world without these new rules. After the crisis, many investors lost faith in derivatives and there was deep concern about the role of swaps going forward. But these products are absolutely essential tools for investors, mutual funds, pension funds and others who use swaps to hedge certain liabilities or duration risks. As a result of regulatory reform, these risk management tools are now safer and more transparent. They now trade similarly to products that many investors understand – such as futures and equities. There is no question investors are benefitting from this regulation.

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Kevin, how do you see the new U.S. derivatives, clearing and trading rules impacting the market?


 

Kevin: It’s interesting because the new regulations were developed to reduce systemic risk. Our research from 2012 showed that 56 percent of swap trading was done with top five dealers, which is very concentrated. Two years later, after the clearing mandate went through, it actually became more concentrated, which is not what regulators intended.


There are a couple reasons why the market may have grown more concentrated despite the intentions of regulators. It’s often easier to clear a trade in the same place it’s made. Also, the largest dealers moved toward a more strictly tiered client book. Clients that wanted to stay in the top tier – and get access to research, analysts, capital and other benefits – sent more deals through the big players, rather than diversify their counterparty list. So Citadel Securities and others coming into the market is what regulators and investors are looking for – diversifying sources of liquidity.

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Paul, what led Citadel Securities, the firm’s market-making arm, to enter the interest rate swaps market?

 

Paul: We spent a lot of time talking to investors and thinking about the problems they were facing in the swaps market. We looked at our firm’s market-making capabilities and concluded we could make the market much better for investors by offering a superior model.


Under the old market structure, trading swaps involved manual negotiation with a lot of back-and-forth between salespeople, with little transparency around price. By introducing our technological and quantitative capabilities into the market, investors now benefit from immediate execution, firm pricing and consistent liquidity in all market conditions.

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Are the changes in the swaps market unique or do you foresee similar market structure shifts across fixed-income products?


Paul: Potentially, and we certainly hope so. Changes to the swaps market in the U.S. demonstrate the benefit to investors when the playing field is level and all parties have impartial access to make or take pricing. It’s Citadel Securities’ view that impartial access should be applied to all markets so investors can benefit from more sources of liquidity, greater competition and the innovation that comes with it.


Kevin: We’re still in the early days of the new regulatory environment. New platforms and new protocols are just being tested. Major dealers will be involved, but there is room for other players to step into the market.


One of the big factors that keeps people from diversifying their counterparty risk is access to new issues. That’s always been the case, but, in the last few years, new issuances have skyrocketed because interest rates have been so low, making new allocations more important than ever. As rates start to go back up, then maybe access to liquidity and best pricing becomes more important.


Paul: I think that’s a great point. The new issuing system allows incumbents to protect their market share because customers need access to new issues. Some part of the market will shift organically to platforms that offer the best price. In corporate bonds, it may take longer.


Kevin: Electronic trading of corporate bonds will pick up. Right now, about 15-16 percent of the corporate bond trading in the U.S. is electronic. That could rise to 20 percent over the next few years, which doesn’t sound like a big change, but it’s pretty dramatic.

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Kevin, look into your crystal ball. Give us one or two predictions for how these markets will evolve over the next five years.


Kevin: For swaps, on the execution side, we’ll see more market participants over time. Once the rules are aligned between the EU and U.S., we should see more natural flows and more natural competition.

On the clearing side, the market will remain relatively concentrated. Hopefully the capital rules will change, making it a more appealing business and encourage more participants to enter. Regardless of where the rules end up, this is a capital-intensive business, so participation will be relatively limited. I think we’re on the right track to a more efficient market.


I think the big questions are: Do we end up with true order book trading? And what role do futures have – not just swap futures?


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Paul, how do you see Citadel Securities’ role evolving?


Paul: We’re going global with this business. We recently launched in Europe to provide liquidity to customers in Europe and Asia. We’re going to launch additional currencies by the end of the year, and we’re about to go live providing liquidity in U.S. Treasuries. Credit is also a natural market for us, which we will intend to enter in early 2016.


We see this as a momentous and historic opportunity – not just for Citadel Securities, but for all investors and for the market structure as a whole. Five years from now, the entire investor experience in fixed-income markets can be better. We want to keep building and delivering superior models for liquidity, transparency, and service – in more markets, in more places.

 

Paul Hamill, Citadel Securities
Paul Hamill joined Citadel Securities in 2015 as the global head of Fixed Income, Currencies and Commodities. He is responsible for growing Citadel’s fixed income market- making operations. Prior to joining to Citadel, Mr. Hamill worked at UBS as its global head of Currencies, Rates and Credit execution services. Mr. Hamill has an M.A. in Political Science from the University of Glasgow, and an MSc. in Finance from the University of London.


Kevin McPartland, Greenwich Associates
Kevin McPartland is a Principal at Greenwich Associates where he leads the firm’s market structure and technology research. He has nearly 15 years of capital markets industry experience with a deep expertise in OTC derivatives and financial services technology. Prior to joining the firm, Mr. McPartland was with BlackRock, where he was a Director in the Electronic Trading and Market Structure group. Previously, he served as a Principal at TABB Group, where he founded and led the firm's Fixed-Income research practice.