By Peter Madigan
With just over a month until swap execution facilities (Sefs) can open for business in the US, it’s still not clear how users will know – at the point of execution – that their trades will be within the risk limits set by a futures commission merchant (FCM) and a central counterparty (CCP), and will therefore be accepted for clearing. Markit and Traiana claim to have the answer – both are launching new, centralised credit-checking facilities – and can point to public support from Sefs and FCMs that are connecting to these hubs.
In private, though, some FCMs are less supportive – the service promises clearing certainty but does not provide it, says one. The banks say they are hooking up to the hubs simply to keep their options open. But they are also bypassing the two services and building direct connections to the Sefs, so checks can be carried out by either pinging messages back and forth, or pushing client credit limits to each trading venue – exactly the job the hubs were set up to do (Risk May 2012, pages 31–37).
An executive at one New York-based FCM outlines one of two key criticisms – that a CCP will end up replicating the check performed by a hub. “Say an FCM uploads its credit appetite for a certain fund to a hub. The hub gets pinged by a Sef that the fund wants to do a trade – and there is sufficient credit, so the hub tells the Sef to permit the trade. The problem is, no Sef is doing anything with that information currently – they are not attaching the clearing commitment data to the trade – so when the trade is sent to the clearing house, the CCP does not distinguish it from a trade that has not been through a hub. The CCP will still message the FCM to ask whether it will stand behind the fund’s trade. At present, the process of uploading lines to a hub is duplicative – it’s a charade.”
Another New York-based FCM puts it more bluntly: “The whole process becomes nonsense – total nonsense.”
The hubs respond by suggesting the problem lies with the FCMs, rather than the Sefs. If a clearing bank was willing to guarantee it would accept a trade that has been through a hub, the subsequent check by a CCP would not be necessary, they argue. Traiana’s chief marketing officer, Nick Solinger, claims some FCMs are heading in this direction.
“Screening client orders is the regulatory obligation of the FCM, and they can do that check themselves, delegate it to a hub or delegate it to the Sef or CCP. Nearly all FCMs have a preference to use a hub or directly connect to Sefs. That screening is not automatically a legal obligation to accept the trade for clearing, however. The decision to offer a guarantee of acceptance is up to each FCM and there are FCMs that plan to offer a clearing acceptance – contractually – if orders are put through our hub,” he says.
The second big complaint is that – after checking with an FCM that a client has not breached its credit limit – a CCP will also check to make sure the clearing member is within its own limits at the clearing house. This second check could also result in a trade being rejected, and FCMs say the majority of Sefs do not have the requisite ‘double-ping’ credit-checking capability in place.
Both MarkitServ and Traiana say they have the functionality for CCPs to push their credit appetite for FCMs to the hubs, removing the need for both the clearing member and the CCP to be pinged – but dealers do not see this happening. Since the CCPs will still be running final credit checks for cleared over-the-counter trades not routed through the hubs, FCMs say it is unlikely a clearing house would outsource the credit check for a portion of its book, and some doubt a CCP would agree to hand over any part of its risk management procedure to a third party.
Traiana’s Solinger accepts complete pre-trade certainty is currently beyond the hubs, but he points out that no other market participants can provide it either. “At present, no hub, FCM or Sef can guarantee an order limit check ensures the CCP will later accept the trade on behalf of the FCM. Solving for both checks is true clearing certainty and will be an ongoing area of effort by the industry to achieve. We view it as a good thing that the CCPs will, for now, continue to send all trades to the FCM for approval, as there will be voice trades and block trades that are not executed on Sefs that will still need extra screening,” he says.
That is not good enough for one New York-based FCM. “The issue is not about whether to use push, ping or hub – the problem is that none of these approaches has any teeth and that neither hub is solving the problem that needs to be solved. Pre-execution certainty of clearing is what we are looking for here, but none of the actors in the transaction lifecycle is putting any weight behind it,” he says.
Timing is another worry. Despite assurances from both platforms that they are ready to start their limit checks today, some Sefs doubt the hubs will be operational by the October 2 deadline, given they are still connecting with FCMs, CCPs and trading platforms (Risk July 2013, pages 21–24).
The hubs disagree. While both are currently testing their platforms with FCMs and Sefs, Traiana says its Credit Link platform “is ready and is in production now”, while a MarkitServ spokesman says its Credit Centre hub is also “ready to go live right now”.
But market participants want a failsafe. Although trading venues are connecting to the hubs, some Sefs and FCMs say they need to have a direct, bilateral connection in case the hubs aren’t ready in time, or to activate as a backup if one or both hubs are out of action for any length of time.
“The key question for hubs is whether they will be ready for game-time now Sefs are preparing to launch and the mandatory compliance date is weeks away. FCMs will need to have direct connectivity to Sefs, just in case, or they risk losing customers. The smart ones have already moved to do this,” says Jamie Cawley, chief executive of Javelin Capital Markets, a New York-based Sef.
In addition to Javelin, Sefs including Bloomberg, GFI Group, MarketAxess, SwapEx, Tradeweb and start-up exchange TrueEx confirmed to Risk they are adding direct connections to clearing members in order to conduct pre-trade credit checks. All the venues say they are also willing to use the MarkitServ and Traiana hubs if their clients request it.
Another question is whether competing hubs fatally undermine the whole concept of a centralised limit-checking facility. Jon Williams, head of US markets at Tradeweb in New York, says a hub needs widespread support to work, and a rival hub immediately hurts that ambition. “In theory the hub is great, so long as a majority of the FCMs are connected to that hub and utilising it. Two hubs reduces the efficiency of the original solution and it doesn’t really seem to make any more sense to apportion credit out to multiple hubs than it does to apportion credit out to a large number of trading venues,” says Williams.
The inefficiencies created by having two hubs is an issue MarkitServ and Traiana acknowledged when speaking to Risk in April, with representatives predicting one utility will eventually win out (www.risk.net/2258392). That may take time, but some market participants are not too worried.
Ron Levi, chief operating officer at interdealer broker GFI Group in London, argues the split allows the two hubs to play to their respective strengths. He says the firm’s Sef will use different hubs depending on the asset class of the trade. “We don’t necessarily want to go down the road of connecting to the clearing houses or the FCMs or both, since it is complicated and time-consuming, so we will be using Markit and Traiana for different segments of the market depending on which asset class we are talking about. Markit’s natural strength is in interest rates and credit, while Traiana has a very good handle on the foreign exchange market, for example,” says Levi.
Other Sefs, though, argue that if a single client’s credit capacity ends up being managed across two hubs, an FCM will have to continually update credit limits in the same way it would across multiple trading platforms – put simply, having two hubs may not make the process much more efficient.
“Traiana and MarkitServ have not developed a centralised position as yet, but I would be surprised if two hubs were able to emerge as viable, long-term utilities. If there are two hubs that are not sharing information or cross-documenting when an FCM’s client trades, then the FCM is effectively still managing those credit lines,” says one prospective Sef operator. “Say an FCM pushes a portion of a client’s credit line to one hub for forex and uses the other hub for rates swaps, the FCM is still managing in real time the credit lines for that client itself – but it’s just managing across two hubs rather than a dozen trading venues. In that case, do the hubs add any real value?” he asks.
The hubs say they add value by constantly rebalancing and updating the credit available for a client at other trading venues as lines are drawn down – as well as keeping the actual size of a clearing client’s credit lines out of the hands of Sefs themselves and minimising information leakage.
Jeff Maron, a managing director at MarkitServ in New York, highlights another reason why FCMs are connecting to hubs – it avoids having to pick winners in the Sef world. Connecting to a hub prevents buy-side firms and FCMs from having to make unnecessary connections to Sefs that fail to gain traction once the execution mandate takes effect. “There are pockets of liquidity out there, but since we can’t know which Sefs are going to succeed or fail, why would I pay to build connectivity to all of them when I could hook into one hub and have access to everything that’s out there through one connection?” he says.
But while buy-side participants are said to have been the most keen to get the hub model off the ground, not all are convinced. If liquidity ends up boiling down to a small handful of trading venues, says one asset manager, there may not be a need for a hub at all. “If, as many people suspect, we are going to end up with two or three venues in credit, rates and forex, why do we need a hub? A lot of dealers are asking the same thing. The dealers are supportive verbally but they are already building direct connections to the Sefs because they do not want to be answerable to a hub,” he says.