Lynn Strongin Dodds looks at why the growth for execution of derivatives via SEFs has so far been gradual and how the players are jockeying for position in the derivatives market
Although expectations ran high, swap execution facilities (SEFs) have not taken the derivatives trading world by storm. In fact, instead of a brave new era, the landscape looks similar with voice trading remaining a firm fixture and incumbents dominating the electronic front. If the past is any guide to the future, though, then alterations will be gradual.
One of the main reasons behind the overly optimistic prophecies is as one market participant put it, “In the media, only the loudest voices were heard but if you met with the trading teams at traditional asset managers and insurance companies who were among the heaviest users of interest rate swaps, they were used to doing business via voice and request for quote and you would have known that the trading was not going to change immediately.”
“The higher share for RFQ trading as opposed to anonymous CLOB (central limit order book) trading has led people to express disappointment that the market has not changed as predicted in the interest rate swap (IRS) space,” says Nick Solinger, head of product strategy and chief marketing officer at post trade service provider Traiana. “However, I find this a little bit surprising because if you look at the history of transitions in electronic markets, you’d expect a more gradual move. Most asset classes including equities, futures pit trading and FX have taken a longer period to move to fully electronic models even if there were regulatory drivers.”
Grigorios Reppas, CDS Product Manager at MarketAxess, agrees, adding, “It will be more of an evolutionary rather than a revolutionary change. There has been much more movement in our space – credit default swaps (CDS) – because the scope is more defined and there is greater liquidity due to the US and European credit indices. Also, it is a much smaller market than interest rate swaps.”
These trends are reflected in the latest Tabb Group study – SEF Trading October 2014: An Expanding Universe. It showed that CDS enjoyed steady growth with over 85% of notional volume being executed through SEF platforms compared to the less than half in early April, when the consultancy published its first progress report. Interest rate derivatives (IRD) have had a much bumpier ride with activity dropping precipitously due to participant uncertainty and the adoption of a wait and see attitude.
The autumn may have marked a turning point with the latest figures from Tabb showing On-SEF notional volumes for cleared interest rate swaps (IRS) in October peaking at $2.9 trn, outstripping the previous month’s record by just more than $83 bn, setting a new all-time record for monthly SEF trading activity. This total represents a 31% jump above the previous year to date 2014 average and a 95% increase from the 2013 monthly notional average traded.
“We have seen a significant migration because of the increasing scope of contracts covered by MAT (Made-Available-to-Trade (MAT) determinations,” says Anthony Perrotta, director of fixed income research at Tabb Group. In addition, the Federal Open Market Committee (FOMC) signalled the end of quantitative easing and the uncertainty this is likely to generate coupled with the eventual hike in interest rates, will likely mean a long-awaited return of volatility and, with it, a natural demand for swaps.
It will not happen overnight though. Kevin McPartland, head of research for market structure and technology at Greenwich Associates and author of its latest report – SEF Landscape – Beyond the Numbers –believes current market conditions will continue to stymie growth. “Volumes have been low across the board in the fixed income universe and there are not a lot of incentives for buy-side firms to change their behaviour because there is nothing for them to hedge in this low interest rate environment. Our report also showed that volumes picked up in the autumn but I think it was more to do with summer ending and people becoming more comfortable with how things worked.”
Buy-side firms have yet to grow accustomed to the new entrants who by industry estimates total around 30. Both the Greenwich and Tabb reports found that despite the proliferation over the past year, the seven main contenders continue to rule the SEF arena. This is especially the case with the CDS market where Bloomberg has the lion share with a hefty 75% while GFI, Tullett, Prebon, and BGC Partners trail far behind although they are slowly building share for interdealer platforms.
As for the interest rate space, liquidity is more spread out with Bloomberg and Tradeweb accounting for around a third at 17% and 13% respectively followed by interdealers Tradition, which is part of Compagnie Financière Tradition, BGS Partners and Tradeweb each with a 14% slice, Tullett Prebon at 13% and ICAP on 6%, according to Tabb. Meanwhile the Greenwich study notes that the majority of investors preferred sticking with the tried and tested trading protocols such as the name give-up request for quote (RFQ), which is most similar to the old voice RFQ.
“Characteristically, people are going to continue to do what they did before which is why it is not surprising that the liquidity is coalescing around the incumbent providers such as dealer to client platforms and the interdealer brokers,” says Jeffrey Maron, managing director at MarkitSERV, the OTC derivatives trade processing service of Markit. “For those moving large orders, the RFQ works well because they do not want to have the execution risk transferred to them as it would in the CLOB. Many buy-side firms with large orders still also opt for voice trading because they want to reach out to the dealers or brokers to see who is offering the best price”.
Jim Myers, senior manager, business consulting trading and risk management at Sapient Global Markets, adds, “It makes a lot of sense that the established players are taking the lead right out of the box. With the advent for mandatory trading on SEFs, people were more concerned about the trading itself and ensuring that their hedges or positions were in place. They were less focused on finding the best overall solution for their trading needs. However, over the next 12 to 18 months I think people will look more carefully at the liquidity, fees, execution modes and other value-added services that SEFs can offer and we could see the market share of the incumbents change.”
Solinger agrees, noting that “It is a big change in the IRS market especially for traders to move from voice to electronic. It seems many buy-side and sell-side traders are comfortable starting with RFQ and have chosen to trade this way before embracing other types of electronic execution trading protocols. I think harmonisation between Europe and the US should further help the market’s development, but it will not happen overnight. Start-up SEFs will need an appetite for a longer ramp up period. Some seem to be gaining traction by specialising, offering compression or compaction services, or offering hybrid execution models.”
McPartland also believes SEFs will have to differentiate themselves by providing unique functionality—whether it be compression tools, the ability to handle package trades or innovative order types. “This may prove enough for nascent SEFs to attract the liquidity needed to gain wide distribution over time,” he adds.
Another avenue smaller venues could explore is offering sponsored access. This would enable buy-side firms to trade directly through a futures commission merchant (FCM), thereby removing the legal and administrative burdens of on boarding to multiple SEFs, according to Paul Gibson, business consultant at Sapient Global Markets. “If incumbents are unwilling there is the potential for large sell-side firms to use less well known facilities and offer trades to clients on their own behalf. It would help but not everyone is willing to provide sponsored access. Even if they did though, the volumes would not magically appear and it would take time.”
Ironically although there are still several SEFs waiting in the wings, takeovers are already in the air and not all of it has been friendly. In late October, BGC Partners launched a hostile $675m bid for rival interdealer SEF GFI after negotiations between the two broke down and GFI opted for CME’s $580 m offer. There will surely be other configurations in the future and when the dust settles the general consensus is that over the next two years, the larger players will become the predator leaving only a handful left.
