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”
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.
- SEF or OTF: A Comparison of Swaps Trading Reform in the US and Europe
- SEF 101: Deconstructing the Swap Execution Facility
- Buy Side OMS and EMS: Integration, Expansion and Consolidation
- Talking to the Swap Execution Facilities
- A conversation with Chris Ferreri, MD of Hybrid Brokerage at ICAP
- A conversation with Jim Toffey, CEO of Benchmark Solutions
- A conversation with Lee Olesky, CEO of Tradeweb
- A conversation with equity SEF eDeriv
- A conversation with Rick McVey, CEO of MarketAxess
- A conversation with Jamie Cawley, CEO of Javelin
With so much focus on execution methods and block trade rules, little talk has been had about another SEF requirement: surveillance. Keeping your market participants in line is no small task. Here is what Javelin is doing to tackle the surveillance requirements.
This is the PR for my latest SEF report, for which the executive summary can be found here.
Dec. 8, 2011, 9:33 a.m. EST
Skepticism Grows across the Swaps Markets about Benefits of SEFs Due to Overly Prescriptive Rules, Says TABB
Over 200 Swaps Market Professionals Rate the Top Firms They Believe Will Succeed as SEFs for Rates, Credit, Equity, Energy and FX Asset Classes
NEW YORK & LONDON, Dec 08, 2011 (BUSINESS WIRE) — Three years after the Lehman bankruptcy and one year since the Dodd-Frank Act was enacted, swaps market industry professionals tell TABB Group that overly prescriptive swap execution facility (SEF) rules, specifically the 15-second rule and the 5 RFQ requirement among others, will have a negative impact on liquidity.
According to new research released publicly today, “SEF Industry Barometer: Fall 2011,” skepticism is rising across the swaps markets concerning the benefit of implementing SEFs, says Kevin McPartland, report author, a TABB principal and director of fixed income research. The report’s analysis is based on responses from over 200 buy-side and sell-side market participants in the US and Europe, including dealers, SEFs, interdealer brokers, asset managers, proprietary traders, hedge funds, commercial end users, G14 and non-G14 global investment banks and agency brokers, futures commission merchants (FCMs), IT providers, exchange/clearinghouses and consultants.
Although the CFTC and SEC expect to begin the implementing SEF trading mandates by the third quarter of 2012, over 80% questioned do not expect implementation until 2013. Asked if they believe that SEF formation will be good for the swaps market, nearly three quarters said yes but this is down from 87% as reported in TABB’s April 2011 report, “Swap Execution Facilities: An Industry Barometer,” also written by McPartland.
“Trade sizes for credit default swaps (CDS) and interest rate swaps (IRS) are expected to see the most dramatic decline during the next five years,” McPartland says. Average trade sizes in every asset class — credit, energy, equity, FX and rates — are expected to decline by at least 25%. “The biggest decline is expected in rates and credit.”
Despite concerns regarding overly prescriptive regulation, McPartland points out that there is no lack of interest in this industry sector. Over 43 firms have expressed an interest in creating a SEF, a list available to TABB Fixed Income Research Alliance subscription-based clients and individual firms purchasing the report. Asked who they believe will be successful ultimately as a SEF in each asset class, the participants named the following firms: Bloomberg, CBOE, CME Clearport , CreditEx, FXAll, ICE OTC Energy , ICAP , MarketAxess and Tradeweb.
The complete list of 52 rankings broken down by asset class can be viewed by TABB clients and firms purchasing the report.
“Although we still see little clarity as to how the swaps market will function going forward,” McPartland explains, “that has not prevented the swaps industry from innovating and creating new business models and technology to ensure liquidity in the swaps market remains, despite the frustrating regulatory uncertainty.”
The SEF report with over 20 detailed exhibits is available for download by TABB Group Fixed Income Research Alliance clients and all pre-qualified media at https://www.tabbgroup.com/Login.aspx . For an executive summary or to purchase the report, visit http://www.tabbgroup.com or write to firstname.lastname@example.org.
About TABB Group
TABB Group is the financial industry’s strategic advisory and research firm focused solely on capital markets. Founded in 2003 and based on the proven interview-based research methodology of “first-person knowledge” developed by founder Larry Tabb, TABB analyzes and quantifies the investing value chain from the fiduciary, investment manager and broker, to the exchange and custodian to help senior business leaders gain a truer understanding of financial markets issues. For more information, visit www.tabbgroup.com . In January 2010, TABB Group launched TabbFORUM, the online community currently with nearly 10,500 capital markets members, drawn from buy-side and sell-side firms, exchanges, regulatory agencies, academia, consultants, vendors and media, focusing on issues covering current industry-wide topics.
SOURCE: TABB Group
martinrabkinink Martin Rabkin, 914-420-5739 email@example.com
The articles speak for themselves, so I won’t reiterate what they’ve already said. But in short, the industry is continuing to push for less prescriptive regulations all the while preparing for what is to come.
“The main message we are hearing from the industry is that they should be left to decide how to trade swaps and that the rules not be overly prescriptive,” says Kevin McPartland, director of fixed income research at Tabb Group.
“Despite the unknowns, complexities and costs, the dealer community feels that it is ready for change,” says Mr McPartland. “Yes, lobbying will continue on both sides and politics will persist, but the dealer community sees the advantages of a mostly cleared swaps market.”
TABB Group is conducting a study to gauge the industry’s views on several swap execution facility issues. The study is a follow-on to research we conducting this past spring entitled Swap Execution Facilities: An Industry Barometer, which was utilized by regulators and industry participants to make key strategic decisions and to understand market perception of SEFs and SEF related issues (see an overview here).
Please click on the link below to take part in the Fall 2011 SEF Industry Barometer. The survey should only take about 15 minutes to complete.
As always we appreciate your input. If you have any questions please feel free to e-mail me directly.
SEFCON II is on Monday, October 3. Chris Giancarlo who’s both the head of the WMBAA and Executive Vice President at GFI Group came in to speak with us about what we should expect to see at SEFCON II. The agenda for the event was also published today – quite a list of politicians and top level industry folks (and any industry analyst or two). See you there.
Rick and I discuss the electronification of the corporate bond market, how that will impact swaps trading and SEF creation as well as the steps MarketAxess is taking SEF-if-fy its platform.