By Anna Reitman
Swaps execution facilities (SEFs) are ready to go and the race to operate is on. These new infrastructures are the industry’s answer to Dodd-Frank rules that push derivatives onto electronic platforms and through clearing, but making a decision for the buy side still looks like a confusion market place.
Over the past few years of rule making, a variety of business interests lobbied hard for infl uence and now that those rules are fi nalised, everybody is a little bit unhappy—a situation that Tabb Group says may indicate that the Commodity Futures Trading Commission (CFTC) performed a good balancing act. About two dozen venues are expressing interest in becoming a SEF, with Bloomberg taking an early lead being the fi rst to apply and receive approval.
According to a Tabb Group survey of dealers, buy-side fi rms and trading venues, the vast majority of respondents, at 84%, believe that Bloomberg will take more than 1% of the overall market in notional outstanding terms. CME and Tradeweb followed closely with 76% and 75% of respondents respectively. For markets valued in the hundreds trillions of dollars, such market share is a lucrative proposition.
Will Rhode, principal and director of fi xed income at TabbGroup, says that in the short term known entities with “desk-top real estate” are going to win. That’s because the swaps market is traditionally voice-brokered and incumbents that are electronic versions of this environment are a familiar model. On the other side of the emerging landscape are exchanges, which will benefit from the futurisation of the swaps market as a result of rules that make trading onexchange less capital intensive for firms.
Hardest hit may be single dealer platforms and there is speculation to what extent they will be threatened as bilateral execution diminishes, but Rhode points out that there is potential to play the role of aggregator. “A single dealer platform has to be some kind of avenue or window into SEF-land. The question is how does [it] fit its network and connectivity to enable clients to take a single view of SEFs or SEF pricing,” he says.
One thing is for certain, the market is in for a shake-up. “We are at the cusp of a market structure that nobody has the authority to dictate how it is going to play out, [regulators] have thrown it at the industry to come and do it as they see fit,Rhode adds. He points out that investment banks have invested many millions of dollars into developing platform technology and are looking closely at how they can reinvent themselves in the new environment.
Not all SEFs are created equal, and the protagonists are focusing on different types of clients and products to begin with. The OTC space has been a two-tiered structure with inter-dealer markets for wholesale and brokers in the dealer-to-client space. With the advent of SEFs, market structure will likely begin to move towards a central limit order book (CLOB) model found in equities, exchange-traded futures and options for most asset classes, according to consultancy firm GreySpark Partners.
Bloomberg has been in the dealer-toclient derivatives trading business since 2003 and about 1,000 firms use its existing execution platforms. Bloomberg’s SEF launched for clients on October 2 when the CFTC’s rules took effect. Tradable products include credit, rates, FX for the non-deliverable forward and options market with plans further down the road for equity and commodity derivatives.
Ben Macdonald, Bloomberg’s head of product, says that initially he expects to see people making use of the request-forquote (RFQ) system before eventually moving to a CLOB system. He comments that over time, the number of people using order book functionality will likely increase as a result of more futures commission merchants (FCMs) signing on to provide certainty and market participants becoming more comfortable with the technology, including understanding that there are no issues between the FCM or the central counterparty clearinghouse that is clearing the trade and firm pricing.
Essentially, Bloomberg’s SEF is the same system that clients are using today with additional plumbing to meet new market infrastructure mandates, he adds. Tradeweb has also been singled out as a strong contender. Since launching in 2005, its derivatives platform has executed more than $14 trillion in notional volume.
More than 20 liquidity providers and over 340 institutional clients currently participate across its derivatives platforms for interest rate and credit default swap indices. Ahead of the clearing mandate, volumes for cleared swaps trade have increased to 85% of all derivatives trading. CEO Lee Olesky says that offering different protocols gives customers choice in accessing liquidity and executing unique investing strategies.
Moreover, the firm has applied to register two different SEFs with separate technology platforms that support alternative methods for derivatives trading: a disclosed RFQ system and an anonymous CLOB. It’s no secret that buy-side firms will look for anonymity to protect their trading strategies as the derivatives market pushes towards mandated transparency.
In general, the different SEFs will offer anonymous trading for at least some functionality but which features are included varies. Javelin’s CEO James Cawley believes the ability to trade anonymously will be a major discerning factor and the company has designed its platform to have RFQ and CLOB functionality that will both trade on a disclosed or anonymous basis.
Cawley declined to give exact figures of clients signed up to start trading, but did say that there are now a number of liquidity providers along with buy side clients such as hedge funds, insurance companies, asset liability managers and commercial banks. In addition, Javelin has signed up agency platforms to its system, which means it will not be relying on swaps sales from particular firms but will compensate agency firms or swaps dealers for bringing customers.
He points out that though the race for liquidity is the most obvious competitive factor, the next phase will be all about distribution. “There are 20 to 30 dealers out there, so there is no shortage of liquidity providers. I think really how this game plays out is how do you compete and how do you put your platform on 2,000 desktops. That is the challenge,” he says.
State Street has entered the SEF race in a unique position. Called SwapEx, its SEF is part of the firm’s new Global Exchange division that will deliver proprietary data, insights, analystics and trading solutions. State Street’s platforms span FX and fixed income and it is planning to offer FX spot forward swaps, FX options, US treasuries, interest rate future swaps, extending into OTC interest rate swaps.
Martine Bond, head of trading and clearing solutions at State Street Global Exchange, says that they are looking toleverage the firm’s established technology expertise and existing platforms. “There will be clients that want to have us on the desktop and where we can, we will be pushing to be there. There are other ways to connect to our SEF and we’ve spent a lot of time making sure that we can be flexible in working with clients on this,” she says.
As a case in point, she notes that the firm’s platform, FX Connect, is used by a large number of asset managers and hedge funds globally to transact their FX trades with multiple counterparties, but they also end up accessing the firm’s back-office integration software. As the SEF deploys, clients will continue to use FX Connect on the front end while trades will go through SwapEx in the back without the need for more desktop space.
Just as exchanges benefit from a vertical structure, so too State Street intends to make the most of its position as a major global firm and custodian through its DerivOne offering, which spans trading, clearing, collateral management, general custody and back office reporting services. Clients can go with this end-to-end service or plug and play into their own infrastructure.
Collateral in particular may become a huge challenge for buy side firms facing the reality of posting both initial and variation margin when mandates take effect across the world. “Each jurisdiction is different from a regulatory perspective. Each clearing house is different from what [collateral] it will allow and is comfortable with but we have a whole range of solutions being deployed successfully to help clients address those problems,” she says.
Other emerging SEFs are looking to fit into a specific product niche, such as MarketAxxess in the credit space. It has been an electronic trading platform exclusive to institutional investors and dealers for about 13 years in fixed income and is used by about 1,300 buy side clients and 85 market makers across Europe, Asia, North America and recently expanding into Brazil.
Though not ruling out extending into other asset classes, the target right now for the company is to start as a credit-only SEF as an extension of its current activities trading credit default swap (CDS) index products. In addition to CDS indices, which are regulated by the CFTC, Market- Axxess also offers CDS single names and index options. “We specialise in developing technology for electronic trading.
What we do for a living is [support] the liquidity of the asset classes [and] we support and try to provide trading protocols for the market participants to execute efficiently,” says Grigorios Reppas, CDS product manager. He adds that one of the biggest priorities over the last few years has been investing in analysts, sales and technology focused on CDS in Europe and the US. How that investment translates into cash spent is somewhat unclear. While some of the major firms setting up SEFs see it as a natural extension of their business, others are setting up from scratch.
Of the companies that provided figures, one reported costs of $20m with half that amount going to technological spend. Another would only say that the estimated cost of SEF registration, not taking into account full development and sales costs, is over $5bn in the first year of operation. Bradley Wood, partner at GreySpark Partners, says that this seems like a reasonable figure for spend because much of the infrastructure and connectivity required is already being done in the equity markets. “If anything, the change is going to be operational rather than technological,” he says.
The comparison between SEFs in fixed income and the emergence of multi-lateral trading facilities in equities markets does warrant some attention for those seeking to predict how the new structures will play out. Wood says that this latest tranche of regulations are encouraging competition and are reminiscent of RegNMS and Mifid. “It will be a bit like the advent of Turquoise, Chi-X and BATS,” he says.
This assessment does however come with a caveat in that cash equity products have very different characteristics, as there is no duration risk or cash flow obligation, for example. If there is high liquidity in a particular swap of specific duration, he explains, that can have implications on the likely liquidity available for a similar swap at a shorter duration. “The nuance in the way swaps are actually structured, you can see differences in…liquidity pools for these products compared to equities.
In that respect they are very different,” he says. Still, the fact is that at some point there will be far greater volumes of available swaps trading data in an environment of multiple venues and fragmentation, which has in the past led to arbitrage opportunities and by extension could lead to the potential emergence of quantitative methodologies such as algorithmic and high frequency trading, Wood says.
“It is not beyond the realm of possibility at all that people are looking at swaps as a new battleground for algo trading. You would be remiss I think not to consider it if you are a fund manager at a hedge fund,” he says. Discussing the ramifications of such an evolution may be premature, and experts do expect fixed income to remain a principal- based business for some time.
But shifts towards an agency model have been observed. “We are seeing evidence [of ] tier one sell sides recasting their fixed income businesses as agency outfit. They are literally providing access to wholesale liquidity and charging a commission to their clients for doing so. It is no longer about managing risk on your balance sheet, it’s about passing through flow,” he says.
Speculation over which participants will win and lose as financial market reforms roll out will continue, and those who position themselves strategically first will be well-placed to reap rewards. But when various players asked what the most pressing concern is, the response is that the buy side is unprepared for the basics right now.
“A lot of [the buy side] are faced with mountains of data and marketing. It is a very significant challenge and given the urgency in which they have to do this, a lot of them will just pick their current prime broker and that could be a mistake. You may find there will be a second pass as buy-side firms slowly become more savvy,” Wood says.