By Philip Alexander
Swap execution facilities are supposed to be central to the efforts of the Dodd-Frank Act to make the derivatives industry safer, but delayed rule-making has thrown their very existence into doubt.
Swap execution facilities (SEFs), together with central clearing and trade reporting, are vital to the Dodd-Frank Act’s efforts to improve the regulatory oversight of the derivatives industry and reduce the risks of swaps trading causing financial contagion between banks. In 2013, all derivatives currently traded over the counter (OTC) that are eligible for central clearing must also be traded via SEFs, which will connect to the clearers.
What is a SEF?
Here is the problem. The Commodities Futures Trading Commission has repeatedly delayed producing final rules on SEFs, which means there has not even been a formal registration process yet. Somewhere between 25 and 50 companies have apparently signalled their intention to apply for registration.
“From a process viewpoint, it takes time to lay the piping, so to speak, so we have to get started. But what SEFs will we connect to, and from there, to what clearers will we be connected? It leaves us facing the possibility that we have to bet on which SEFs will ultimately manage to bring in the business,” says Gary DeWaal, special adviser to the US arm of brokerage NewEdge.
Many dealers are taking the safe route, and moving toward SEFs offered by established trade platforms such as Bloomberg or TradeWeb. But more specialised players may provide a better offering for certain swaps products, requiring further study by buy-side and sell-side communities to choose their best SEF.
“What we offer is full transparency on pricing, with no tiering of participants or shielding of prices except on block trades, showing the full depth in the stack in real time and allowing trades against real prices. And at the same time, participants are anonymous. In addition, we already have dealers signed up. No other SEF candidate that I know of has managed to combine all three,” says James Cawley, chief executive of Javelin Capital Markets, which is a specialist candidate SEF for interest rate swaps and credit default swaps.
What is the alternative?
Futures exchanges are keen to offer one, the so-called designated contract markets (DCM), which can be launched now rather than having to wait for the SEF rules.
Previously, the two advantages of the OTC swaps market would have been the degree of customisation available on each trade, and the willingness of dealers to accept non-standard collateral – unlike exchanges. Since the requirement to clear centrally removes the second advantage, only the customisation remains to keep end-users in the swaps market. But DCMs may have a head-start of at least six months on the delayed launch of SEFs, so they have a good opportunity to persuade participants to make the switch.
“Some swaps products clearly lend themselves to the kind of homogenisation needed to move them onto futures markets, especially interest rates. Others, such as credit default swaps on single names, would be harder to transform,” says Mr DeWaal.
What do investors think?
Andrew Karsh, global fixed-income and commodities portfolio manager for the $245bn California Public Employees’ Retirement System, says there could be greater collateral efficiencies for investors routing trades through exchanges rather than SEFs. But liquidity in the DCMs may be less dependable unless contract standardisation occurs.
In either case, investors have a further choice, since both SEFs and DCMs allow buy-side members to participate directly. The buy-side will be weighing up whether to disintermediate the banks.
“Investors use multiple futures commission merchants [FCMs] to ensure best execution, but if all the FCMs are running trades through the same futures exchanges, then it may be better for us to go direct. The counterparty risk would be improved, but there would be questions over what collateral pool the exchange would require compared with the FCM,” says Mr Karsh.
What do banks think?
Dealers are not giving up on SEFs just yet. A market structure strategist for one large broker-dealer says the central limit order book on an exchange that simply connects buyers and sellers directly may work well for the most super-liquid contracts, but market makers are still helpful for most derivatives.
“Some exchanges say they have a future that is the exact economic equivalent of a certain swap, but cheaper. If the economics are really the same, then why the price differential?” he asks.
As long as the SEF rules contain the requirement that they can handle a request for quotes (RFQ) to five dealers for each trade, then SEFs will offer investors a way to find liquidity with discretion, rather than having to wait for it in the futures markets. But joining the SEF directly might not be so appealing to fund managers.
“If a SEF participant crosses the $8bn volume mark, then they may be instructed to register as a swap dealer, which comes with much heavier regulatory costs,” says the dealer. Better to leave that to the flow monsters.