Swaps market: Fight looms over which model is best

By Michael Mackenzie


A new era is close at hand for the US derivatives industry and the battle lines are being drawn up over two very different approaches to how the vast swaps market will trade in the future.

In the wake of the financial crisis, regulators have pushed for a transparent and safer over-the-counter (OTC) swaps market. Under the 2010 Dodd Frank Act, the solution has been a move towards clearing the credit risk of swaps in conjunction with fostering electronic trading that encourages live prices being widely publicised.

In the coming months clearing begins in earnest and the US Commodity Futures Trading Commission is expected to finalise swap trading rules for new venues, known as swap execution facilities, or Sefs.

While the swaps industry has long been preparing for the arrival of Sefs, an alternative way of trading is also gaining momentum, the designated contract market (DCM), or listed futures exchange model.

For more than two years, the swaps industry has aggressively lobbied the CFTC, Congress and other regulators with the aim of preserving much of the existing swap trading model via Sefs. Those efforts have sought to forestall OTC swaps from trading like interest rate futures, where trade sizes are smaller and transactions more frequent.

But the ground is already shifting beneath the swaps industry with the Chicago-based CME, the largest US derivatives exchange, set to start trading a swaps future contract via a DCM with the help of banks such as Goldman Sachs, Credit Suisse, Citigroup and Morgan Stanley.

The move is seen as a shot across the bows of the nascent Sef model and suggests some banks are taking an open view as to how the swaps market will develop.

“The swap market is going to change, the current status quo will not survive,” says the head of electronic trading at a big dealer that will make prices for the CME’s swap future.

This month, Tabb Group, the consultancy, released a report called “The Death of a Sef” that argued the DCM model is better placed to capture electronic swaps trading. “The enthusiastic start-ups have been beset by delayed regulatory timelines and entrenched behaviours, but also by being in the no-man’s-land of trading venues,” says Tabb. “Sefs have the same amount of regulatory burdens as an exchange, a narrower slice of the derivatives market and will largely depend on the survival of the status quo.”

DCMs also have an advantage over Sefs in being allowed to set the size of large swap trades on their platform. That could encourage large institutional investors to trade on DCMs rather than Sefs, which face stricter rules.

“We are seeing the proliferation of new futures products,” says Donald Wilson, chief executive at DRW Trading Group, which cofounded the Eris Exchange that supports swap futures.

IntercontinentalExchange plans to introduce a future for credit derivative indices next year. Meanwhile, ICE and the CME plan to convert cleared energy OTC swaps to futures so that investors and traders can avoid tougher capital rules.

For prospective Sefs, frustration with the delay in approving rules combines with concern that DCMs may have an advantage.

“Every day that goes by without clarity on rules is bad for transparency and the democratisation of the swaps market,” says James Cawley, chief executive at Javelin, a nascent Sef.

Other prospective Sefs are ready to revise their models. Vinayek Singh, chief executive at Vyapar Capital Market Partners, says that while it has been preparing to register as a Sef, the current uncertainty across the swaps industry requires a flexible approach.

“If DCMs end up covering most of the standard market, that’s where dealers will transact. We are prepared to modify our approach, either as a Sef or as a DCM,” says Mr Singh.

Lee Olesky, chief executive at Tradeweb, the electronic trading platform, says: “We currently plan to register as a Sef.” However, should the OTC market develop over time towards a DCM model, Mr Olesky says they would evolve with the market.

But he says pushing swaps towards just one type of model is unwise: “It’s not a one size fits all market.”

Chris Ferreri, managing director at ICAP, the interdealer broker, says moving the swaps market towards a futures-style market raises questions for the industry about stifled innovation and reduced competition among trading venues as a futures contract trades only at the exchange it originated in.

A bigger concern is the dilution of tailored swaps that offset specific interest rate risk. Once interest rates rise, many investors may be caught out by relying on a future rather than a swap that better matches their interest rate risk.

Mr Olesky says: “It makes sense to have a variety of options to trade swaps in order to create a stable environment that meets customers’ differing needs.”

Mr Ferreri adds: “Large asset managers, for example, make use of swaps as a way to precisely mitigate risk and that is not as easily achieved through futures.”