By Rob Daly
When President Obama signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law on July 21 last year, it started a 12-month countdown for the US Commodity Futures and Trading Commission (CFTC) and US Securities and Exchange Commission (SEC) to create a new market structure for the venue-based trading of over-the-counter (OTC) swap instruments.
The new trading venues, known as swap execution facilities (SEFs), are supposed to bring more transparency and standardization to the various OTC swaps markets. Trades will be executed on the SEFs, which in turn will report trade details to various newly minted swaps data repositories (SDRs) and will be cleared via a selection of clearinghouses.
Although the CFTC and SEC continue to work out the details of the market structure for OTC swaps, many say the process is eerily similar to a previous market transformation.
“Look at the energy markets post-Enron,” says Jeffrey Maron, head of administration, e-commerce, at inter-dealer broker GFI Group. “In the last 10 years, we’ve seen a shift from a bilateral market to a cleared market and one that has been opened to a great number of participants in an open-access forum, which we envision is similar to the many-to-many provision set within Dodd–Frank.”
Since the change in the energy market over the past decade a number of clearinghouses have joined the market, new trading venues have sprung up and exchange- and OTC-based trades take place on trading screens while block and OTC trades are transacted over the telephone.
New Market, Familiar Faces
Since the drafting and passage of Dodd–Frank, the number of estimated SEFs operating after the July 15 deadline has varied widely across the industry. During the second half of 2010, regulators estimated that as many as 70 SEFs could be in operation the following year.
“In theory, anyone can become a SEF,” says Paul Zubulake, a senior analyst at Boston-based industry research firm Aite Group. “All they need [to be a SEF] is open access and to be connected to all the clearinghouses,” he adds.
Yet that number has shrunk considerably when the CFTC decided to mandate that CFTC-regulated SEFs seek multiple sources of liquidity, thereby knocking single-dealer trading platforms out of the mix. But all is not lost for single-dealer platforms, as the SEC, which regulates securities-backed swaps, is considering allowing SEFs to have a single source of liquidity for dealer-to-client swaps transactions, which would let dealers register their respective trading platforms as SEFs.
“It’s too early to say, though we believe there will be fewer SEFs managing the bulk of the OTC derivatives volumes due to the power residing in the incumbent voice franchises and the gravitational pull that multi-product, multi-asset-class and multilateral venues such as BGC Partners already have in place,” says Jeffrey Hogan, managing director, head of business development at BGC Partners.
Establishing an SEF will entail some effort, but it will not involve the reinvention of the wheel, according to a number of inter-dealer brokers.
“Many of the parts needed to build an SEF exist today, but not all,” says Maron. “Some of the compliance, reporting and dissemination issues as of this date remain unclear and will continue to be issues that we face.”
For inter-dealer broker Icap, most of the necessary SEF-enabling technologies will be a combination of new and bolt-on technology to its existing platforms. “Clearly, as an SEF there will be some additional responsibilities in the core principles outlined by the CFTC and the SEC that we don’t deal with today, but we feel capable of dealing with them when they become a finalized rule,” says Edward Brown, executive vice president of business development and research at Icap electronic broking.
Unlike the inter-dealer brokers that have long-established infrastructure and market connections in place, Javelin Capital Markets seeks to stake out its own real estate in the SEF markets. Founded in 2010, Javelin plans to be a player within the interest rate swaps (IRSs) and credit swaps market.
In preparation for the Dodd–Frank rules, Javelin executed and cleared its first IRS trade last summer. “We cleared it through the International Clearing Derivatives Group (ICDG), which is the clearinghouse related to Nasdaq OMX,” says James Cawley, CEO of Javelin Capital Markets. “We currently connect to the Chicago Mercantile Exchange (CME) clearinghouse and are in the process of connecting to ICDG and the IntercontinentalExchange (ICE) formally and expect to connect to LCH.Clearnet as soon as they are ready to comply with US regulations,” he adds.
The firm is using a platform based on the trading system developed by inter-dealer broker IDX Capital, which Cawley helped found in 2005. “We acquired the intellectual rights for the technology from IDX Capital and have since made several changes and upgrades to the technology,” says Cawley.
When Javelin launches its trading platform, firm officials expect it to be one of the few anonymous electronic order books serving the interest rates and credit swaps market.
Most other organizations planning to register for SEF status expect to run their trading venues on a request-for-quote (RFQ) basis due to the thin liquidity in most swaps markets.
“If you look at the most actively traded index contracts, they probably trade a few hundred times a day,” explains James Rucker, head of operations, credit and risk at MarketAxess. “A few of the other index and single-name contracts trade as many as 50 times a day. However, most of the single-name index contracts trade only a few times a day on average, with many of them not even trading every day.”
Only interest rates-based and “on-the-run” US Treasury-based swaps are large and liquid enough to be traded via an order book. “As you go to the old, double-old and triple-old and then the ‘far-off-the-run’ issues, there is less and less liquidity in them and they trade more by hand and are driven by people that have specific interest in the instrument,” says Maron. “I might own the triple-old 10-year treasuries and I need a price on them. It will be more difficult to find a price, especially for size compared to something on the run,” he adds. “We see the same thing in interest rate swaps.”
Zubulake, meanwhile, says he sees it as an RFQ market, which can be the way that cash treasuries trade on Tradeweb or Bloomberg.
Getting the Plumbing Right
Besides implementing a trading platform, SEF operators will face similar issues negotiated by exchanges, ECNs and alternative trading systems (ATSs) that operate in a many-to-many market structure like linking to multiple clearinghouses and trade reporting facilities.
According to Maron, middleware will play an important role in the new market structure as dealers will want to avoid writing interfaces to each clearinghouse’s and SDR’s application programming interface (API).
“We have a lot of strategic connectivity and are already working on putting this in place,” says Rucker.
One of the most difficult portions of establishing a SEF will be installing the proper market surveillance, according to Maron. If SEFs need to run similar compliance scenarios as exchanges, they are going to have to step up their game as they will need to run a variety of tests in real and near-real time, he says. It will be a steep learning curve for some as they will need to monitor other markets for halts, daily limits and underlying derivable markets for delivery issues, he adds.
MarketAxess, which plans to launch an SEF specializing in credit default swaps (CDSs), will look for third-party surveillance offerings—both fully outsourced offerings as well as software packages. “We’re not sure, but it’s one of those areas where there are probably economies of scale for a provider that can offer a solution across multiple SEF venues,” Rucker says.
On the other hand, Icap will look to leverage the market surveillance systems that it currently has in place for its existing core offerings.
One issue that has not yet been addressed by the regulators and the industry is the prospective fragmentation of liquidity as each type of SEF-eligible swap will be able to be traded on a handful of SEFs. Introducing multiple independent venues will affect how clearing members will allocate their credit appetites among their clients, explains Christopher Perkins, US head of OTC derivatives clearing at Citigroup.
Perkins suggests that the industry should consolidate limit-checking so whenever an execution occurs, the venue handling the trade would ping an industry utility that checks credit and eligibility per clearing member. “In that way, it gives almost real-time certainty that the trade will be accepted and cleared,” says Perkins.
A second issue that the industry needs to address is the development of a “give up” document, which will define the legal relationship between the executing counterparties and clearing members, and who is at risk to whom. Currently, the industry is working with the Futures Industry Association (FIA) to develop such a document, but “we have a long way to go before the give-up document is defined,” says Perkins. “Once we have the give-up document and the legal relationships established, putting the proper operations in place will follow.”
Now that there are four months left before the regulators need to finalize all the rules regarding SEF operations, many in the industry are wondering if the current deadline will slip.
“Any planning or implementation we are doing is based on the July 15 deadline,” says Brown. “However, we recognize that the CFTC and the SEC have said that there are a number of issues that are tangential and some that are completely ancillary to the debate the could affect the timeline—for example, funding from Congress. It’s fair to expect some delay in the timeline but we’re not using that at all. We are preparing for operations in the 90 days following July 15.”
However, other inter-dealer brokers are planning to be fully operational by the original deadline. “It is not the obligation of regulators to allow ample time for the industry to respond—it is rather the duty of service providers such as BGC to put systems in place to meet the deadlines outlined in the rules to ensure clients can operate in a compliant environment,” says Hogan.