A look at how SEF volumes have fallen and risen since the Feb 17 start date and the ongoing challenges of cross-border market fragmentation and regulatory reform of derivatives execution. Lynn Strongin Dodds explores.
Before the regulation hit in mid-February, cyberspace was buzzing about the different trading formations that would evolve on Swap Execution Facilities (SEFs). Predictions ranged from traders circumventing the new platforms via products such as swap futures to volumes spiking to liquidity fracturing. The reality is somewhat different more than one month in and it could take several more weeks for clear trends to emerge.
“There were a lot of conversations before the mandate about how traders would avoid the Made Available for Trade (MAT) mandate,” says William Rhode, principal, director of fixed income at Tabb Group. “However, our new study shows that is nothing to support the anecdotes. We do not see a pattern of avoidance nor do we see the fragmentation that was talked about. One of the reasons is that we are only six weeks in and it is too early to build assumptions in a systematic way. The jury is still out. However, we are seeing consolidation with Bloomberg emerging as the main winner.”
In fact, a new study by Tabb Group shows there are signs of both adoption as well as avoidance when focusing on a specific subset of the interest-rate swaps (IRS) market within the jurisdiction of the MAT determinations. Trading may have gotten off to a slow start with volumes slumping but by the end of the sixth week of mandatory SEF trading, average monthly value traded On-SEF for IRS contracts bound by SEF execution mandates rose from a pre-MAT average of $540 bn to a record $824 bn. In notional terms, the level of MAT credit default swaps (CDS) traded On-SEF grew by a staggering 350% while average value traded On-SEF paled by comparison at just over 60% during the five-week period.
Colby Jenkins, research analyst and author of the report notes though that smaller swap users who were not already trading via SEFs struggled as the MAT deadline represented a costly, cumbersome process of SEF on-boarding. The research firm analysed historical trade data and examined a spectrum of forward-starting and backward-starting swaps, as well as swaps with adjusted coupons, swaptions, package trades, and so-called “broken date” transactions, to determine any trends away from SEFs following the MAT determination.
“It may prove easier for some firms to simply fine-tune the instrument, so that it becomes non-MAT allowing then to continue to trade Off-SEF. However, to-date, evidence of this occurring remains murky at best,” notes Colby. “While, in broad strokes, we did find that there was a significant growth in the combined notional volume traded in March for both forward-starting and backward-starting swaps, it is hard to describe the phenomenon as a trend.”
The results are perhaps not surprising as no one expected all market participants to be ready the week of 17 February deadline. There were a plethora of issues to contend with such as the need to sign new contracts with platforms and dealers, the confusion over the handling of bunched orders and the general confusion inherent with any major change. As always the bigger firms with the deepest pockets and resources were better equipped than their smaller brethren to cope.
“The challenges of setting up the infrastructure depended on the size of the firm,” says Dr. Anshuman Jaswal, senior analyst with Celent’s Institutional Securities & Investments Group. “The smaller to medium-sized buy-side firms had more problems than their larger counterparts. However, even when the infrastructure was in place, there were questions in terms of the proportion that would be traded on SEFs, swap futures and bi-lateral OTC derivatives. The other main issue is liquidity and for now we are seeing the established players are attracting most of the volume.”
This is in contrast to last year where there were fears over fragmentation. According to the Tabb report, dealer-to-client venues are attaining the vast majority of liquidity with Bloomberg leading the charge in the majority of the newly mandated product set traded via SEF. In the credit markets alone, the top six dealer to client venues accounted for 97% of the volume, with Bloomberg grabbing the lion share at 72%. TP SwapDeal came in second with 8.3%, followed by GFI at 7%, Tradeweb with 6.5% and ICE and MarketAxess comprising the rest.
The answer for the trend is relatively straightforward – familiarity. “There are between 15 to 17 SEFs but the top players are capturing the volumes because it is easier for clients to use a provider and tools they already know,” says Bob Holland, senior product manager – fixed income and derivatives at global solutions provider Linedata. “Similar to equities, people will gravitate to where the liquidity is and follow the path of least resistance. All they have to do with Bloomberg or Tradeweb for example, is press a button on their desktop and they are connected to the SEF. It may be tough for some of the smaller firms to break in. Volume is the key deciding factor: “volume begets volume.”
Although trading within the US may be consolidating there are ructions between the US and Europe. New research from the International Swaps and Derivatives Association (ISDA) shows the introduction of SEFs has led European firms to trade less with US firms for euro-denominated interest rate swap contracts and this indicated a “possible unwillingness of European dealers to transact with US dealers”. The numbers tell the story with the percentage of euro-denominated swaps traded on SEFs dropping from just under 10% to around 4% between February 15 and March 28. Sterling-denominated swaps were less affected but still slipped from just under 4% to 2% in the same period. The data is based on swaps trading data reported to the Depository Trust and Clearing Corporation (DTCC).
Although the G20 countries may have vowed to adopt a more centrally cleared and electronic world, many are moving at their own tempo. US and European regulators have attempted to harmonise their efforts in order to avoid loopholes and duplication but they have not always been successful. For example, US policymakers have grappled with how to monitor their markets participants when they trade with overseas counterparties. To this end the Commodity Futures Trading Commission (CFTC) and European Union struck a deal whereby overseas swap trader and venues could use multilateral trading facilities (MTFs), and set a May deadline for registration.
However, in its latest no action relief letter, MTFs may be able to get a reprieve if they, for example, they report all swap transactions to a Commission-registered or provisionally-registered swap data repository as if it were a SEF and certify that it is subject to and compliant with regulations that require all MTF participants to consent to the MTF’s jurisdiction, thereby enabling the venue to effectively enforce its rules. In addition, qualifying MTFs must submit monthly reports to CFTC staff summarising levels of participation and volume by people in the US.
Winning a place on the CFTC MTF approval list will largely be down to meeting the requirements laid down by the UK Financial Conduct Authority (FCA). In other words, the venue has to conduct non- discretionary business on an almost purely electronic basis which is in contrast to the telephone-based world of a US swaps dealer. To allow for this group, there are suggestions that the MTF definition will need to be flexible and interdealer brokers have been talking to the FCA about changing standards to allow voice trading. If that is the outcome, it could effectively create a European SEF.
If this doesn’t come to fruition then one alternative is the CFTC would have direct supervision over pockets of business in the London market. ICAP, the world’s largest interdealer broker, has already applied to run a London-based, US-compliant SEF. Although this may sound like a sensible solution, the fly in the ointment could be MiFID which has its own separate category – the Organised Trading Facility (OTF) – that addresses trading in illiquid instruments on a discretionary basis. Europe and the CFTC will have to set standards for substituted compliance with these venues as well.
“One of the problems is that there are two regulatory environments and there has been fragmentation,” says Sassan Danesh, managing partner, Etrading Software. “The CFTC will allow trading on approved MTFs but what about OTFs or other venues? The overall level of clarity is still insufficient, despite the CTFC’s no-action relief letter of 9 April. Also, they are very different markets with historically a higher percentage of swaps being traded electronically in Europe than the US. However, recently, we have seen more engagement and stronger cooperation between the CFTC and Esma (European Securities and Markets Authority). It is encouraging but you also have to be cautious as regulation will move at its own pace.”
* Listen to our 9 minute “SEFs: What’s Next?” to hear more from Sassan Danesh of Etrading Software about how the volume of derivatives through SEFs will evolve now the initial hurdle has been crossed.
