SEFs infrastructure progresses as deadlines loom
The market structure needed to support trading of over-the-counter derivatives on so-called swap execution facilities is rapidly evolving, a new report has revealed, with a range of venues seeking to capitalise on the new electronic trading environment for standardised rates, credit and FX products.
The Dodd-Frank Act, written into law in June 2010, mandated that centrally-cleared OTC swaps also be traded on an exchange or via SEFs. The G-20 stated in a 2009 communique that such reforms should come into force by the end of 2012 at the latest.
SEFs: the Business Landscape, a report published by capital markets consultancy Greyspark Partners, identified 52 potential SEF offerings, while focusing on the top 12 venues based on product coverage, volumes and current market share.
This top tier of SEFs predominantly consists of inter-dealer brokers such as ICAP and Tullet Prebon, and trading platforms such as MarketAxess and Tradeweb. However, it is still unclear whether the large population of more fledgling offerings can stand the test of time.
“The big multi-asset platforms like Bloomberg are likely to stick around for the long haul. Then you’ll have single asset class specialists like Creditex that will try and establish themselves as the preferred liquidity pool for that asset class. The rest may find they’re not able to maintain a sustainable business,” said Bradley Wood, partner at Greyspark Partners.
“There will be a level of consolidation among SEFs. That said, regulators are keen to ensure there is sufficient competition, so fragmentation will remain and aggregation will be necessary. We saw that in the equities space with MTFs – some tried and failed. We’d expect to see the same in derivatives,” he added.
The report noted that interest rate swaps and credit default swaps were the primary target for most venues, with quite a few also looking at FX products. Of these, interest rate derivatives are expected to be the most traded of the asset classes on SEFs, with 50% of the current product set already being centrally cleared.
Equity and commodity derivatives are lower down the priority list, with only a handful of venues examining launching offerings in each case.
Many of the large, multi-asset class venues are aiming to provide a one-stop liquidity shop for rates, credit and FX products for both the dealer-to-dealer and dealer-to-client markets. There will also be more niche providers that target a particular client base or asset class.
Greyspark believes there will be a trend towards central limit order books (except in the case of FX products) along the same line as for the equity markets. This means banks should be forced to compete for smaller margins and lower ticket sizes for vanilla products, ultimately increasing volumes.
At the same time, request-for-quote functionality will be required for larger trade sizes. Wood notes a number of venues are also offering auction capabilities, some of which are unique to that venue. “This enables larger transaction sizes to be traded in the dealer-to-dealer space,” he said.
Risk standards
There appears to be some divergence in terms of risk management standards at SEFs (see chart). While certain safeguards such as “fat finger” protection will be relatively commonplace, circuit breakers appear to be less popular. There is also debate as to the role of central counterparty trading controls, which via direct connectivity to a CCP can source any limits, blocks or other pre-trade risk functions on particular clients stored at the clearing house.
“There is a lot of variety in what venues offer in terms of pre-trade risk management,” said Wood. “One example is around CCP-sourced trading controls. We expect to see more thinking on that front, with some venues really interested in developing those capabilities.”
Wood believes SEFs will take an agnostic view on which CCPs to connect to, although the bigger clearing houses such as CME, ICE and LCH.Clearnet have attracted the most amount of subscriptions so far.
Meanwhile, it appears that banks are not as far down the line in their preparation for the new SEF trading world.
“Banks are less prepared in terms of which venues they’re going to connect to. For one, people anticipate that the 60-day deadline will be pushed back to January 2013. There is also the political angle to consider if the Republicans re-capture the White House,” said James Peoples, senior consultant at GreySpark Partners.
