With the expected explosion of possible number of SEFs, how will market participants determine which SEFs to use? Neal Brady, ceo of Eris Exchange and Cliff Lewis, executive vice president of State Street Global Markets weigh in on SEF selection in recent DerivSource webinar.
The introduction of Swap Execution Facilities (SEFs) for the electronic execution of some Over-the-Counter (OTC) derivatives will allow for greater transparency in the market but will also introduce a significant shift in the way derivatives trading is conducted. The number of SEFs that will launch to capture some of the market share remains unknown however, some have speculated expect as many as 40 SEFs may launch with the those less successful faltering as the new market landscape evolves. In a recent DerivSource webinar, the panel addressed this issue of SEF selection and explored how market participants can differentiate between SEFs from an array of product offerings.
Neal Brady, ceo of Eris Exchange identified some of the key areas, which should be considered when selecting an appropriate SEF. In the product area, SEFs will have to define the products that they are making available to trade. “On the product side, if you are trading rates you are also likely trading credit,” he said. “Certain venues will offer all assets classes, while others will specialize in one asset class, such as interest rates, credit or FX.”
When operating in the cleared world, the product is not only the market you see on screen or the execution venue, it is also closely tied to the back office where the product is being cleared, explains Brady. Once clients have traded a product, they will want to know the ultimate carrying cost meaning, the cost of putting up margin and holding the position at a clearinghouse.
According to Brady, market participants should ask whether the margins against a product might offset other futures contracts or related swap products and what the overall costs are, not only the execution costs on screen, but the fully loaded cost of trading or executing a hedge.
The use of the Request for Quote (RFQ) model, in which quotes must be requested from five dealers as proposed by the Commodity Futures Trading Commission (CFTC), will have a significant impact on liquidity fragmentation and best execution. The RFQ model seeks to offer some level of transparency, though some market participants are concerned that it could lead to a divergence with the Securities & Exchange Commission (SEC) rules and widen spreads.
In addition to RFQ, the other trading model for SEFs is the Central Limit Order Book (CLOB) execution method, which offers anonymity and streaming quotes for benchmark derivatives. The RFQ model can also offer streaming quotes or directed quotes to liquidity providers, states Brady. The key question here, said Brady, is whether the execution remains anonymous as in a CLOB, or if there is name disclosure on the client side as in certain RFQ systems.
The key differentiators and areas of focus for clients should be – the nature of liquidity on the platform, who supports the platform, who determines the pricing, and who can easily access the platform, adds Brady.
The degree of trading infrastructure in the form of front, middle and back office integration is another point for consideration when selecting a SEF.
Brady said: “The key questions to ask when selecting a SEF are: does the venue have an open Application Programming Interface (API)? Are the markets available on existing distribution platforms or front ends? Do the Independent Software Vendors (ISVs) supporting the SEF offer credit controls embedded in the platform allowing a user to instantly trade and clear?”
Diverse industry participants would like access to a variety of execution methods compatible with their individual needs. Those trading large volumes fear lack of anonymity, information leakage and overall price impact if they were to trade on several exchange markets. The rationale for restricting choice in execution is the desire for greater transparency.
Cliff Lewis, executive vice president of State Street Global Markets identified three categories of customer during the DerivSource webinar, The first being those customers that have accepted the inevitable and are well down the path of preparing for the coming changes, the second who are indifferent and ” hoping this all goes away…” although this is unlikely to happen, said Lewis. The third customer type includes those who are looking for the simplest solution that minimizes disruption to the status quo.
Who ultimately benefits from SEFs was a key question addressed by Lewis during the panel debate.
Lewis said: “There are a number of offerings which are really designed by, and for, the benefit of the dealer community. The large banks have pricing models which show this; they charge the buy-side and the money is distributed to the sell side in the form of dividends, although this is one extreme example.”
Lewis said that some offerings are trying to push the market to a more level playing field and democratize the market. The buy side will, for the first time, have the transparency and efficiency to get better pricing. There are contrasts however, in SEF models that have yet to translate into buy-side decision-making.
Lewis concluded that ultimately the successful SEFs will be those chosen by the buy side as seen in other asset classes such as FX. This will be driven by the people who use these products, not by the market makers, he added.
Many market participants would prefer that SEFs be gradually phased in, given the need for the market to build the necessary infrastructure to connect to SEFs and for SEFs to connect to clearing houses and swap data repositories. The introduction of SEFs, it is hoped, will address some of the weaknesses in the current market whilst preserving some of its strengths.
