During the same shoot for the video on OTC clearing, I spoke with CME about the demand for data center space in financial services and how that impacts their strategy for the new Aurora, IL data center.
Regulations will have a significant impact on how SEF aggregators function and how widely these aggregators will be adopted by various market participants. Some of the most contentious rule proposals are those that will have the greatest impact on liquidity fragmentation. They include the 15-second rule, the ability to voice trade, the “block trade” definition, best execution requirements, and the requirement to send an RFQ to five dealers. The Smart Automated Agency Broker (SAAB), think swaps smart order router on steroids, will not only help traders execute the right product at the right price, but it will also mitigate regulatory complexities.
Much of the complexity has to do with the regulators’ goal of increasing transparency in the market. The thing we have to remember is, market participants are hypocritical when it comes to transparency: They want to get transparency, but don’t want to give it in return. While regulators work to pass rules that increase pre-trade and post-trade reporting, the market will push to ensure simultaneous regulatory compliance and trading anonymity via smart and flexible technology.
The Rules of Engagement
There are those at the CFTC who dislike voice trading on a SEF because they believe it limits the market’s ability to see all available bids and offers on the screen in real time. Because most swaps products are fraught with complexities and trade with relative infrequency, however, being able to speak to a broker directly about market pricing remains a necessity.
By way of compromising with the industry the CFTC has instituted what has come to be known as the “15-second rule.” It states that two parties may prearrange an order over the phone, but the order must then be displayed on the open market for 15 seconds. This communicates to the market the intentions of both the buyer and seller, which then creates an easy opportunity to trade ahead of the order. The 15-second rule also allows other market participants to price improve the original arrangement which, in theory, could benefit the buyer.
What does this have to do with liquidity fragmentation? The information leakage created by displaying a prearranged order to the market for 15 seconds is like a football coach giving his playbook to the opposing team a week before the big game. To prevent counterparties from being taken advantage of, large orders will need to be sliced and diced then sprayed across the relevant SEFs-something only a SAAB could do effectively. A firm having to protect its information in this way accounts for much of the swaps market’s expected increase in transaction volume. The percentage of transaction volume that the 15-second rule will impact will largely be determined by the proposed block trade rules.
Both the CFTC and SEC have proposed rules that define the size of a block trade, and allow block trades to be reported to the market after 15 minutes (rather than “as soon as technologically possible”). Treating a block trade differently than smaller orders is common in regulated markets. What’s of concern to us isn’t that block trades exist, but how they are defined.
The swaps market is a block-trade market by definition (the average interest rate swap is $129 million). The recent CFTC block trade rule defines roughly one third of the market as block trades (the details of this rule are explained well in another TabbFORUM post). Conversations with various market participants have left me to believe that the current rule is much more reasonable than the original proposal which would have seen only 5% of the market defined as a block. However, assuming that an interest rate swap block trade will be roughly $250 million or higher, a large swath of traders concerned with execution anonymity that routinely trade IRS sized between $100-200 million will quickly realize the only way to do that size without create a market stir is via a SAAB.
The 5 RFQ requirement and order interaction rules will not cause fragmented markets, but they will impact how the SAAB functions. The CFTC’s “5 RFQ” rule requires that all RFQs be sent to at least five different liquidity providers. The SEC has countered with a proposal that RFQs must be sent to “one or more” liquidity providers. TABB Group believes the CFTC will lower the number of liquidity providers that must be contacted from five to two. Still, the SAAB would need to know the relevant regulator for each product and act accordingly. This is most critical for credit traders, as index CDSs fall under the CFTC’s rules, and single-name CDSs, the SEC’s.
SEF best execution rules, more formally known as order interaction rules, will require SEFs to force interaction between their RFQs and CLOBs. Before a RFQ can be acted upon, for example, any better-priced liquidity in the order book would need to be taken out. The SEC has proposed such rules and the CFTC continues to contemplate a similar approach. TABB Group believes this rule is unnecessary. Market participants all have a fiduciary responsibility, whether to their investors, shareholders or brokerage clients, to execute in the most efficient way possible. Furthermore, whether mandated or not, SAABs will take into account all market prices when determining where to trade, regardless of market model. It’s like mandating that we drink coffee in the morning: It’s going to happen anyway, so why bother mandating it?
As a side note, technology can and will help market participants deal with these differences between SEC and CFTC rules; technology might also provide opportunities for those looking to benefit from the rule differences. But this begs the question: If the industry will simply work around the rule differences anyway, wouldn’t it be easier on everyone if there were no rule differences?
Don’t Tell Anyone I’m Here
Buy-side traders will also look to minimize the market impact of their trading in other ways. Sponsored access, as it is known in equity markets, is when a broker allows a client to trade directly on an exchange using the broker’s exchange membership. The broker is still responsible for the orders that go down to the exchange, and so must have pre-trade risk procedures in place, but the client can self-direct trades without any manual interaction from the broker.
CFTC rules allow direct access to SEFs without any broker involvement, but this direct access is only part of the allure of sponsored access in equities markets. Sponsored access also allows the client to trade under cover of the broker’s name, which leaves the market unaware of who is actually doing the trade. This “service,” if it is offered for swaps trading, could be a boon for dealers because it would encourage even large hedge funds to trade through a broker rather than accessing the market directly. The success of swaps sponsored access is inversely proportional to the success of SEFs that offer anonymous trading, because the latter would severely limit the need for the former.
Even if sponsored access becomes common, brokers would still not be able to execute a trade on a SEF and then move that position to their clients’ accounts (commonly referred to as the Principal-Principal model). “Moving” the original trade would be a trade in and of itself. This second trade would then fall under trading mandates, which means that the trade would have to be exposed to the SEF (via the 15-second rule) before it could be executed. That, of course, would generate additional risk and cost to both the client and dealer, making the approach less than desirable.
Direct market access for clients also provides further support for the agency model, and its use of the SAAB. Since brokers cannot profit by taking principal risk, they will instead charge fees for use of their trading tools and physical market access. TABB Group believes the market will ultimately adopt this model. This also brings us to the single dealer portal (SDP).
SDP to SAAB
Under proposed regulations, dealers will not be able to fully own and operate SEFs. This means that SDPs, those that now act as primary sources of liquidity for the buy side, cannot register as SEFs unless owning dealers were to sell off most of their businesses. Therefore, many SDPs are in the process of converting their swap-trading screens to SEF aggregators and SAABs (see Exhibit 1). These conversions are most prevalent among fixed-income platforms focused on CDS and interest rate swaps trading. TABB Group has also seen evidence that platforms that are currently focused on other areas, such as spot FX or US Treasuries, plan to build SEF aggregators to build up rather than dismantle their SDPs. By providing their clients with these new liquidity-seeking tools, dealers can try to maintain the screen real estate and relationships they have spent years establishing, even though those clients will be able to trade directly on SEFs themselves.
This all sounds like a win-win, doesn’t it? Clients get trading tools to reduce the complexity of execution at virtually no extra cost, and dealers can still utilize the SDPs in which they have invested so much. Unfortunately, it might not be that easy. A number of questions still linger as to the regulatory requirements and mechanics of dealers offering such a toolset.
Regulators are working to determine if they should require SEF aggregators to comply with the same kinds of rules with which SEFs must comply. If SEF aggregators provide clients with pre-trade price transparency-one of the core goals of Dodd-Frank-ensuring they do that fairly and consistently is critically important. Based on TABB Group’s conversations with regulators, this additional regulatory burden seems unlikely because nearly everything SEFs do will already be heavily regulated. Besides, several other markets, including equities, futures, options and FX have liquidity aggregators and, to date, regulators haven’t put further oversight in place on any of them.
This post was taken in large part from my research report “Swaps Liquidity Aggregation: Best Execution to Product Selection”
Its no secret that CME is one of the few firms in contention to be a major interest rate swap and CDS clearinghouse. This is a promotional video from CME that I make a quick cameo in, talking about the eventual growth in demand for swaps as the industry gets past the short term pain of change and benefits from the efficiencies of the new model. Its also worth noting that today CME announced its latest swaps clearing numbers. You can also view this video at CME.com.
Back in October I wrote about the impact of an impeding Greek default on the CDS market. I concluded that in the shadow of Dodd-Frank, the decision on whether the Greek bailout triggered a CS payout was a minimal consequence.
With ISDA’s announcement that the European Central Bank’s fix to the Greek bond crisis will not cause CDS contracts to pay out, it seems we will quickly find out how right or wrong I am.
Economically, the announcement today is of minor consequence. According to the Wall Street Journal, the maximum payout would be only $3.2 billion. That amount is certainly not on the radar of systemic risk watchers.
The real issue here is the viability of sovereign CDS. If the market is now left thinking that anytime a sovereign default is inevitable the relevant regulators will structure the event in such a way that it is not technically a default, why buy the CDS at all?
I suspect many of us feel this way about auto insurance – if your policy won’t pay unless your car crash happened on a dirt road on a Tuesday between 11 a.m and 12 p.m., what’s the use? Seems we might be in that place for sovereign CDS.
Rather than reiterate my thoughts, I wanted to bring back attention to the piece I wrote in October: Greece Won’t Kill CDS, Dodd-Frank Will.
My comments on the subject were also picked up by the Wall Street Journal: “CDS, Huh. What It Is Good For? Absolutely Nothin?” Read their coverage at WSJ.com.
As a research analyst I don’t do much in the way of product reviews. Sure we compare and contrast business models, but in most cases we stop short of saying which product is better. This is because we’re not actually users of those institutionally focused products.
Well in this case it’s different. I recently began playing with a new iPad app StockTouch. (full disclosure: they gave me a copy of the app so I, Kevin not TABB, could review it). No matter what market you’re trading in or watching the amount of data available and necessary to keep up keeps getting more and more ridiculous. Hence the proliferation of visualization tools. I remember seeing demos of early stock market data visualization products back in my days at JPMorgan. They were certainly very cool, especially back in those dot com times, but the reality was no trader or analyst was really going to use them. The cultural desire to change just wasn’t there and the quite frankly neither was the software. Finally times are changing.
StockTouch does a great job of providing a view of the entire US equity market (and any particular stocks you want to watch) in a very clean, easy to use interface. They expand on the tried and test green is good and red is bad approach, meaning that by glancing at a sector or two it becomes quite clear where the days market sentiment resides. This works great intraday but also over customizable time periods. My colleagues and I were able to figure out how the whole thing worked without reading any “user manuals”, which is in my eyes a requirement for any iPad app: a toddler (or junior analyst) should be able to make it work in a matter of minutes. StockTouch passes there.
They do however still have some work to do. In entering the symbols in my portfolio it became quickly clear that ETFs are yet a part of the system. They say they are working on that, but in the mean time it’s a big gap. One other key element that is needed to make StockTouch a slam dunk download – integration with your brokerage account. Allow me to not only pull in my portfolio but place trades, and things get really interesting. Clearly this is an app focused at retail investors for now, but in the institutional world platform integration is often the key feature asked for by traders; integration with middle and back office systems, integration with every exchange on the planet, even integration with in-house CRM systems. Luckily for StockTouch the retail world is a little less complicated, however I still thoroughly appreciate the legal and technical challenges of linking the interface to e*Trade or ScottTrade.
But in the end, both institutional and retail brokerages are after one thing – flow. And if this app can bring it than they have no reason not to embrace the possibilities.
If you frequently trade single stocks in your personal account or are just a stock market junkie, StockTouch is well worth the couple of dollars on iTunes. If your goal is to occasionally manage your portfolio, wait until ETF data and trading integration come on line.
I recently spoke with John McPartland, a Senior Policy Adviser at the Chicago Fed (and no, we can’t seem to find a direct relation although it seems there must be one somewhere). Here we discuss the implications of MF Global on the clearing model going forward; was it simply fraud or does it point out flaws in the current system.
I recently spoke with Ryan Sheftel who runs fixed income electronic market making for Credit Suisse. CS is taking its experience from building AES in the equities market to fixed income, leading to some pretty cool trading tools.
I’ve written quite a bit about the fate of single dealer portals (SDP) and SEF aggregation. UBS has finally come forward with what its been working on lately, which involves both its SDP and SEF aggregation. Having seen the demo I can assure you that what they have is real and I believe gives us a small view into the post Dodd-Frank world of swaps trading. Clients can trade with each other (which is big in and of itself) and as SEFs come online (and officially becomes SEFs…eventually) the platform will provide access to the best prices at each venue. But for all dealers this kind of technology is only one piece of the puzzle.
“Dealers are not sure which parts of the business will make the most money postreform–whether execution, clearing or financing–so they’re bundling them all together to see what sticks,” said Kevin McPartland, principal at independent research firm TABB Group.
Each element of the offering needs to work together flawlessly to ensure profitability. As to who is best poised to do that – I’ll leave that question to the buy side firms I’m in the midst of speaking to for my upcoming buy side swaps trading report.
This is another segment from our Fixed Income Trading 2012 event on January 24th. My panel discusses the impact of the Volcker rule on the credit market – the market likely to be the hardest hit by the proposed new rule.
In 2010 I wrote about the value of shaving off microseconds on long distance routes for high speed trading strategies. Spread Networks proved that value by creating and selling its direct link between NY and Chicago, cutting off roughly 3 milliseconds from the roundtrip.
I spend a lot of time looking at the maps back then, and can tell you there is virtually no more direct path between the two cities. I joked in the report that the only way to go more direct was a wire between the Empire State Building and the Sears Tower. Well, it seems McKay and Aviat are trying to do just that (albeit with slightly different end points), with microwaves.
Microwaves can in fact cut time off the round trip, but there are a lot of caveats. The bandwith of microwave is very low. It would be nearly impossible to send the entire OPRA feed in real-time for example. Microwave is also impacted by weather. Bad rain and snow could shut the communications down (it never snows in Chicago does it?).
Conversations I’ve had tell me that the better application for microwave is short term links – say Mahwah to Carteret. Even still, it seems the NY-Chicago route will come online and inevitably people will jump on board. Quite frankly I don’t think it will hurt Spread that much, but it does present an interesting new option. Apparently low latency isn’t dead.