Does Dodd-Frank Affect OTC Transaction Costs and Liquidity?

Y.C. Loon is a Financial Economist at the U.S. Securities and Exchange Commission and Zhaodong (Ken) Zhong is Associate Professor of Finance at Rutgers Business School. This post is based on an article authored by Mr. Loon and Professor Zhong. The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author’s colleagues on the staff of the Commission.

In our article, Does Dodd-Frank Affect OTC Transaction Costs and Liquidity? Evidence from Real-Time CDS Trade Reports, recently published in the Journal of Financial Economics, we use real-time trade reports made available by post-financial crisis reforms to examine the trading costs and liquidity of index credit default swaps (CDSs), an important class of OTC derivatives. More importantly, the richness of the disseminated trade reports allows us to analyze how different aspects of the Dodd-Frank Act’s regulatory reforms are changing the landscape and thus, the liquidity of the once opaque OTC derivatives market.

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Commodity Futures Trading Commission (CFTC) implemented mandatory real-time reporting and public dissemination of OTC swap trades on December 31, 2012. Swap transactions have to be reported to a recordkeeping facility, known as a swap data repository (SDR), which in turn disseminates transaction details (e.g., trade price, trade size, timestamp, and trade characteristics linked to the Dodd-Frank reforms) to the public. We combine publicly disseminated index CDS trades (executed between December 31, 2012 and December 31, 2013) with the intraday quote data and end-of-day valuation data to calculate transaction-level relative effective spread (a key transaction cost measure) and other liquidity measures. The average relative effective spread is about 0.27% of price level or 2.73% of CDS spread, which is in line with the transaction costs reported in other derivatives markets such as the options market. While there is substantial aggregate trading activity in the index CDS market (average weekly trades stand at 5,462 during 2013), liquidity does vary across different market segments. Specifically, index CDS contracts offering credit protection for different types of bond issuers exhibit different levels of liquidity. Further, for a given index CDS contract, liquidity is higher for the most recently issued series (known as the on-the-run series) and for most popular 5-year tenor. These results provide the backdrop for the second part of our empirical analysis: exploring the impact of regulatory reform on swap market liquidity.

The Dodd-Frank Act fundamentally changes the OTC swap market in several ways. First, it requires real-time reporting and public dissemination of transactions, a fundamental shift in the previously opaque market with little or no post-trade transparency. Second, it mandates central counterparty (CCP) clearing for eligible swaps, which were traditionally traded in a bilateral setting without the disciplining influence of clearing, including the posting of margins. Third, it creates swap execution facilities (SEFs), a new type of trading venue where multiple traders can execute swap transactions by accepting bids and offers posted by other traders. In addition, the Dodd-Frank Act separates nonfinancial entities and small financial institutions that use swaps to hedge or mitigate commercial risk (termed “end-users”) from swap dealers and major swap participants. The Dodd-Frank Act also distinguishes between standardized and bespoke (i.e., customized) contracts, and separates block trades from non-block trades.

We first provide evidence of how the Dodd-Frank Act could have affected market quality by studying changes in index CDS liquidity around the CFTC’s implementation of regulatory reforms. We then investigate how trading costs and liquidity are affected by various deal characteristics that came to be defined in the post-Dodd-Frank era. Consistent with finance theory, we find that transaction cost falls and liquidity improves for index CDS contracts after the commencement of real-time reporting and public dissemination on December 31, 2012. These findings are obtained after controlling for a host of liquidity effects that are unrelated to the transparency enhancing effects of trade reporting and public dissemination.

Deal characteristics that came to be defined in the post-Dodd-Frank era—clearing, SEF trading, end-user status, and contract customization—also influence transaction costs and liquidity. We find that centrally cleared trades are associated with higher liquidity than non-cleared trades. This result suggests that the reduced counterparty risk and increased post-trade transparency associated with central clearing have beneficial effects on liquidity. Trades executed on SEFs have better liquidity and incur lower transaction cost than trades executed off SEFs, which is consistent with the notion that increased pre-trade transparency improves liquidity. Despite end user concerns over the potential adverse impact of regulatory reforms on market liquidity, our results indicate that end-user trades in the index CDS market exhibit higher liquidity and lower trading costs. This finding supports the view that qualifying for end-user status validates nonfinancial and small financial hedgers as uninformed traders. We also find lower transaction costs and higher liquidity for bespoke trades, consistent with the argument that market participants primarily use customized contracts for hedging and thus pose little or no adverse selection risk. We obtain these results after controlling for liquidity effects associated with factors unrelated to regulatory reforms.

The CFTC implemented mandatory clearing for four major index CDSs (North American index CDSs: CDX NA IG and CDX NA HY; European index CDSs: iTraxx Europe and iTraxx Crossover) in three phases for different groups of market participants. This phased introduction provides a natural experiment to test for the liquidity effects of various Dodd-Frank deal characteristics while avoiding contamination by endogeneity issues. We find that the liquidity enhancing effects of clearing, end-user status, and contract customization grow as the coverage of mandatory clearing expands. These results strengthen our finding that the Dodd-Frank deal characteristics are related to CDS transaction costs and liquidity.

The full article is available for download here.

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