SunGard’s Daniel Parker talks about the ‘next big thing’ for ISVs as they prepare swap processing services to support the post-SEF environment going forward.
A significant event occurred on May 16, 2013. The U.S. Commodities Futures Trading Commission (CFTC) voted to allow swap execution facilities (SEFs) to unilaterally determine the “made available to trade” (MAT) criteria; which effectively determines which swaps are required to be cleared. This simply means that SEFs, as well as their post-trade service providers, will substantively influence the course of performance for the global swaps marketplace.
The general rule is that all swap transactions that are subject to the trade execution mandate must be executed on a designated contract market (DCM) or a SEF. However, concerning rules, it is often the exceptions that are most valuable when developing the next-generation business models for our customers.
The final SEF rules seem to be consistent with Congress’s mandate to shift the swaps market from a bilateral one to more of a public exchange-style market, with a greater number of participants having access to pre-execution data.
As a result, it is a certainty that market-driven, technology-based business models will emerge, or alternatively, migrate to support SEFs, and their customers, through services such as portfolio compression, risk mitigation, and most significantly, swap aggregation.
The question then becomes, which requirements, if any, will be placed onto technology service providers?
It is undisputed that in light of the CFTC’s final rule, the time has ripened to provide automation supporting the SEF listing, connectivity and processing race. For instance, SEFs are now incentivized to find reasons to list instruments and declare them, “made available to trade.” This so-called “race to the bottom” will likely result in mass SEF consolidation, but before that, we will embark on one of the greatest shifts of market-inspired transparency aggregation in history. Yes, the next big thing.
Therefore, independent service vendors (ISVs) should diligently map their respective offerings in accordance with the market demand for this “next big thing” together with the intricate details of the new bright-line rules.
For example, the CFTC deems that transparency aggregation, market depth, or analytical services provided by an ISV that defer any transaction execution to an independent execution source will not constitute a need for the ISV to register as a SEF. This is true because the ISV is simply providing market visibility or other decision-support functions — while refraining from the actual swap execution.
Conversely, to the extent that an ISV provides integrated execution capability, registration, as well as other related requirements, may, depending on the facts and circumstances, apply.
Additionally, swap support services such as portfolio compression are viewed similarly. Here, the CFTC allows portfolio compression as a netting mechanism, thus reducing a counterparty’s trade count and outstanding gross notional value. The result is a compression exercise that has the potential to alleviate, or at least provide, a viable alternative to collateral scarcity or portfolio margining efficiency — which incidentally remains a significant challenge to many market participants.
In accordance with CFTC guidance, depending on the methodology used, portfolio compression may wholly terminate or change the notional value of some or all of the transacted swaps. The result is a netting that consolidates trades and notional values which is valuable because the compression directly impacts optimization schedules as it relates to risk analysis, margin, and any applicable risk charges. Therefore, depending on the methodology used, no reliance on any external source is necessary to achieve risk and margin optimization.
Note however, that the actual swap execution remains the bright-line test. So to the extent an ISV offers portfolio compression services that supports multi-SEF transparency aggregation, market depth, or analytical services — without providing execution capability — SEF registration is avoided.
Another example is the automation in support of directly managing market, credit and other relevant exposures. Also known as risk mitigation techniques, they are incidentally an integral component of the European Markets Infrastructure Regulation (EMIR). In this case, the focus is on the redistribution of a market participant’s risk elements, without conducting an actual netting calculation. For example, a participants’ ability to identify elements of risk in a portfolio would likely exist in the front office, and the firm would reasonably seek to calibrate pre-execution what-if scenarios or volatility hypotheticals for all points along the maturity or credit curve. This service, as described, may be delegated to an ISV providing risk mitigation services.
It is important to note that the purpose of the SEF rules has been articulated, and the resulting message invites ISVs to embark on the next big thing. Specifically, swap processing services such as transparency aggregation, market visibility, or analytics such as portfolio compression or risk mitigation techniques. Each component is an integral part of a successfully functioning swaps market.
The “next big thing” never comes without its challenges. From a delivery perspective, in this post-SEF environment, it is important to be mindful of separating execution capabilities from a processing services offering – which is the bright-line distinction between leveraging facility execution and being an execution facility.
