Swaps Market Prepares For Its Big Bang

By Michael Mackenzie & Philip Stafford

 

The US swaps market is expected to begin a shift away from the predominance of telephone trading this week as it joins the 21st century in a move towards more tightly regulated electronic trading venues.

The changes are being ushered in by global regulators in the wake of the financial crisis and come into effect on Tuesday, as trading of over-the-counter derivatives moves on to so-called swap execution facilities, or Sefs.

Long viewed as a shadowy area of the financial market, OTC swaps trading has been dominated by large global banks and investors since its inception in the 1980s, but the collapse of some banks in 2008 revealed serious shortcomings within this bilateral system.

The efforts of regulators led by the US Commodity Futures Trading Commission has been to open up the swaps market to greater competition and price transparency. Last year, the credit risk between buyers and sellers of standard swaps was mutualised via centralised clearing houses, setting the foundation for rapid paced transactions on Sefs.

While Sefs facilitate electronic and voice based transactions, many in the industry expect the share of computer driven transactions will quickly escalate from their current very low level.

The biggest concern facing the market is whether banks, investors, clearing houses and operators of Sefs are ready for showtime.

Jamie Cawley, chief executive officer at Javelin Capital Markets, says the mandated era of swaps trading on Sefs, “will be a bit more dramatic than people think”.

He adds: “A number of market participants recognised long ago the inevitability of Sefs coming and have prepared for this. Others however have not.”

Ahead of a hard Sef deadline, the CFTC has announced a number of temporary measures aimed at providing relief from possible last minute problems that could hamper an orderly start for Sefs.

Lee Olesky, chief executive officer at Tradeweb, says: “It’s hard to measure readiness collectively across the market; there will be bumps in the road as the market makes the transition to Sef trading.”

Meanwhile there has been a scramble among some clients to sign up for Sef access, particularly at Bloomberg, whose data terminal is ubiquitous across trading floors.

“We are seeing quite a sizeable chunk of people coming on to the platform,” said Ben Macdonald, president of Bloomberg’s Sef. “The Sef is part of the terminal and it’s very integrated into our clients’ work flow.”

For interdealer brokers used to high commissions from executing billions worth of notional derivatives over the telephone on behalf of banks amid a raucous trading floor atmosphere, the winds of change are certainly blowing.

Michael Spencer, chief executive of ICAP, the biggest interdealer broker and which began in the 1980s with a specific focus on the then fledgling interest rate swaps market, is under no illusions that the old ways of doing business are ending.

“The market in interest rate swaps is still predominantly voice brokered but it’s not where we see it in the longer run,” he says.

ICAP, which has large electronic franchises in Treasury and currency trading, is expected to be more able than many of its rivals to weather the competitive landscape, as the likes of Bloomberg, Tradeweb, MarketAxess, the CME Group and start-ups vie for a slice of the swaps market.

As swaps begin trading on Sefs, an early shakeout is expected among the 20-or-so competing platforms.

Rick McVey, chief executive of MarketAxess, says the proliferation of venues, all interpreting the rules differently, will cause problems for dealers and investors. The high cost of running a venue will also be significant, he adds. “By the end of the year we will be down to around seven venues,” he predicts.

Mr Olesky says, based on the current size of the swap market, that it is hard to see demand for more than several Sefs across different asset classes.

Tradeweb, which has been facilitating US electronic derivatives transactions for more than eight years, is looking to provide investors with ways to trade swaps on a Sef, from streaming prices, anonymous order books, to a request for quote function.

“We are not picking a particular model, the market will evolve,” says Mr Olesky. “We have prepared ourselves for a number of outcomes and protocols given the different types of customers in the market.”

Mr Cawley says: “Sef volumes will increase and it remains to be seen whether customers and dealers use voice or trade electronically on Sefs, but the market will be forever changed.”

 

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