FT Alphaville " Be very, very quiet - we're hunting AIGs As part of the Dodd-Frank Act, various types of participants in derivatives markets need to be defined. According to the jersey one ultimately gets as a trader of interest rate swaps, credit default swaps and so on, different regulations may apply. Where "security-based," regulator equals SEC, otherwise CFTC. One of the reasons for doing things this way is to ensure that there isn't some entity that is significant to the functioning of the market, which goes unwatched because regulators miss what it's up to in buying or selling swaps. In short, there is a lot of effort being made in particular markets, and overall via the definitions for systemically important institutions, to ensure that nothing escapes the regulatory net. Even more to the point: it would be embarrassing to have another AIG. The insurer wasn't short on regulators but none of them effectively regulated its swaps activities. As it pertains to doling out definitions, the SEC published a study on Thursday that profiled all the actors in the credit default swaps market, in order to try to determine who's who. For example, there will be an exemption from a number of regulatory requirements for an entity that "engages in a de minimis quantity of swap dealing in connection with transactions with or on behalf of its customers." But what is "de minimis" in these markets? And what makes a dealer actually a dealer, rather than just a major participant.* The SEC's report looks at all CDS transactions for 2011, both in terms of monthly positions and transaction data. At first glance, FT Alphaville thought the analysis was a bit iffy in its construction, because there are too many "buts." This can be seen when going through some of the proposed metrics that are meant to help separate the swap participants from the dealers, and define what "de minimis" is: Whether an entity transacts with multiple counterparties. As a general matter, entities engaged in dealing activity are likely to have more counterparties than non-dealers. But... to the extent that a market participant limits its activity to the inter-dealer market, it is possible to transact with relatively few counterparties despite engaging in dealing activity. Also, some non-dealers may maintain trading relationships with numerous dealers. Or: Whether an entity's aggregate buy notional amount is within 45-55% of its aggregate gross notional transactions. To the extent that dealing is associated with zero net exposure, a dealer's buying and selling activity should be largely offsetting. Hence, total notional buying exposure should comprise roughly half of the gross notional transaction activity. However, because an entity may buy and sell credit protection for the same notional amount, but on different reference entities or indexes, or with different maturity dates on the same reference entity, a flat order book could nevertheless reflect directional, speculative trades, uncharacteristic of a dealer. Whether an entity's frequency of posting initial margin on orders occurs in less than 10% of their aggregate transactions. This criterion reflects the expectation that, in general, dealers are less likely to post initial margin when trading CDS, particularly in dealer-to-dealer transactions. However... A limitation of this analysis is that reporting initial margin to DTCC-TIW is voluntary. Therefore, since this filter may capture entities that in fact post margin, but choose not to report, the criterion may be over-indicative of dealing activity. It's worth sticking with this though because it turns out that the SEC's graphs and analysis are actually really, really interesting. The trick was to apply multiple criteria at once. Before we get to that though, marvel at the fact that only just over 1,000 entities were involved in the CDS market at all in 2011, in terms of transactions done: That's 87.2 per cent of the CDS trading activity coming from the top 15 dealers. There's a bit of a cluster of participants in the $10-25bn bracket, then the bulk of clients - if we may be so bold as to call them that - had under $1bn of activity in gross notional terms, for 2011. Put the top 15 in your mind again, as we look at this next table that lists the dealers that meet the flat book criterion, which remember is defined as having buy notional amounts comprise 45-55 per cent of all transactions. The unsurprising thing is that not many clients are "flat" and most dealers are - insomuch as the definition can be used, given how many other instruments dealers and clients could be using to balance their books. Frankly what surprised us is that all but one of the major 15 dealers are indeed that flat when looking at single-name CDS trades alone. Next surprise - that one dealer that isn't flat, is a big dealer. The notional drops from $9,367.44 to $7,735.27 when the number of entities in the top bracket goes from 9 to 8. Curious. Anyone want to own up to being a little extra-directional in single-names compared to one's peer group? Hmm? Anyway, let's see how many dealers pass at least three of the five criteria (we listed three above, the other two are: flat in terms of trade count, and transactions with multiple counterparties excepting Isda-recognised dealers). The question this is trying to answer is: who other than the top 15 dealers should count as a major dealer? On balance, does it matter more that they meet these criteria or that the volume traded is over a certain threshold? All of the above tables and graph are from Section I of the report, and use activity data. Section II cuts clearer ICE and Isda-recognised dealers out, leaving the dataset to look a lot more client-y (or potentially AIG-y, for that matter). What we see is that the buyside is doing more protection buying than selling. Also the top 35 non-dealers, by Isda definitions, have 63.41 of the aggregate gross notional. Everything else is pretty spread out among the other 1,153 entities. In tabular format: Are any of the top 35 or so dealers, major swap participants, or just participants? We'll leave that to the rule-writers, busy bees that they are. Thanks for the research though. Very informative. No, it can't just be a straw poll of how many swaps participants refer to a given entity as a muppet client rather than a sworn enemy who must be defeated competitor. Related links: Information regarding activities and positions of participants in the single- name credit default swap market - SEC (the report) Dodd-Frank Progress Report - Davis Polk Staff Overview of the Proposed RulemakingFurther Defining "Swap Dealer" - CFTC This entry was posted by Lisa Pollack on Tuesday, March 20th, 2012 at 13:28 and is filed under Capital markets. Tagged with aig, CDS, cftc, Dodd-Frank, sec, swaps.