SEFs are an integral part of the Dodd-Frank Act. David Easthope, Research Director with Celent’s Capital Markets Group looks at the development of these execution facilities and explains the likely challenges the market faces in implementing the SEF electronic trading architecture in the coming months.
Background
Swap Execution Facilities or (SEFs) will be the required location for electronic execution of centrally cleared, standardized swaps under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). The introduction of the SEF acronym into the capital markets lexicon is representative of the envisioned migration of trading of standardized swaps (which would include some types of interest-rate swaps, credit default swaps, equity swaps, commodity swaps and FX swaps) to electronic platforms where matching of liquidity will take place, and which later feed to central clearing infrastructure and downstream trade repositories. But SEFs are more than just plumbing, and will be a critical component of the evolution of the swaps market structure from non-standardized, bilaterally-cleared to standardized, electronically traded, centrally-cleared swaps.
Title VII
Dodd–Frank is a federal statute signed into law in July of 2010 by President Obama. Dodd-Frank has sixteen distinct titles or provisions, but a major thrust is the writing of dozens of new rules designed to make the over-the-counter or OTC derivatives market more transparent and less risky. Title VII is the specific provision of Dodd-Frank which provides the new regulatory framework for OTC derivatives and moves the US closer to the G20 commitments. Title VII also empowers the CFTC and SEC with primary authority to regulate the swaps market, including transactions and participants.
The legislation requires that standardized swaps be electronically matched, centrally cleared and publicly reported. The final scope of these rules will ultimately depend on how the SEC and CFTC decide on the definitions of certain terms, including the definition of a security-based versus a non-security based swap, the definition of a block trade, reporting timeframe, and what makes a swap standard versus bespoke. Along the way, there will be necessary exemptions to the rules.
SEF Markets
The Dodd-Frank rules establish new swap market mechanisms including swap data repositories and a new category of execution platform called a Swap Execution Facility or SEF. These rules have a number of statutory deadlines which regulators have already missed and will likely continue to miss or extend and the vast majority of rules have yet to be implemented. At the same time, regulators also seek commentary from market participants which tends to slow down rule writing. However, despite these challenges, regulatory rule-making and guidance will continue to advance through the end of this year and into 2012.
The SEF Rule-Making Process
SEF registration rules have been a moving target and are expected no sooner than April 2012. On top of these registration rules, both the clearing and trading mandate must also be in place for SEFs to function as actual SEFs. As a result, a reasonable estimate for SEF implementation would be Q4 2012. While still theoretical, Swap Execution Facilities are almost a reality. By late 2012 or early 2013, SEFs will be the required location for electronic execution of centrally cleared, standardized swaps.
SEF Scenarios
While emphasis in the financial press tend to focus on the total number of new firms that intend to register as SEFs, the majority of potential SEFs will be existing firms and their trading platforms, including inter-dealer brokers, multi-dealer platforms, exempt boards of trade (EBOTs) and designated commission merchants (DCMs).
We note that much has been made of the potential for forty or so SEFs in the OTC swaps marketplace. However, regulatory delay and market conditions have reduced the likelihood of even half that number ultimately being achieved as registrants. At the same time, the majority of the SEF platforms will be incumbents and even the challengers represent industry insiders who k now the OTC markets well.
To protect their market position, unsurprisingly a number of these incumbent platforms have announced that they plan to register as SEFs as soon as possible, with a high concentration around platforms which already support electronic or hybrid trading of credit default and interest-rate (CDS, IRS) swaps. Several of these platforms have been in place for many years and have existing dealer and institutional customers. Incumbents include inter-dealer brokers such as BGC Partners, GFI Group, ICAP, Tradition and Tullett Prebon. Other incumbents which will register as SEFs include multi-dealer platforms such as Bloomberg, MarketAxess, Tradeweb, FXAll, and Thomson Reuters.
At the same time, many new potential challengers have been announced as intending to register as SEFs in the CDS, IRS and FX swap arenas, such as TeraExchange, Javelin Capital Markets, Eris Exchange, State Street SwapEx, and True SEF, among others.
The SEF Development Roadmap
Implementation of the SEF electronic trading architecture into the swaps market structure will take more than registration, clearing and connectivity, but rather a significant investment in IT and operations. Achieving SEF status is also a sequencing problem, as the timing of rules and registration must be synchronized with development. While SEF registration and implementation is a complicated affair, much of the complication involves waiting for the final rules to be in place while anticipating what users will demand in terms of trading protocols.
Furthermore, a prioritized development roadmap will deliver not only integration but also innovation in the form of new trading protocols and an intuitive user experience. However, industry adoption will not necessarily follow SEF innovation. Even the most innovative SEF models must still capture the imagination and liquidity of large institutional players on the buy and sell side. This is no simple task and goes beyond offering new trading protocols, as the success of trading protocols will be determined by the liquidity needs of market participants.
The Future
For dealers and users, both 2012 and 2013 are likely to be choppy in SEF markets as participants try to get more comfortable with the idea of greater transparency and electronic execution on SEFs. For operators, firms must come to grips with the notion that SEF status is a rite of passage, not a guarantee of success, as some SEFs/OTFs will attract liquidity while others will not. Furthermore, liquidity in the broader market will ultimately be determined by how final regulatory rules are written, interpreted, implemented and enforced.
Conclusions
Overall, while we do believe that SEFs will make the swaps market more electronic, transparent and competitive, not all transparency is equal. We especially believe price discovery could be hindered unless careful consideration is taken to make the rules adaptable and to reflect the fact that swaps market has far less liquidity than some people imagine.
Going forward, we anticipate that the ultimate change in the competitive landscape may be less than many observers believe, as incumbent platform operators spend significant resources to develop, maintain and future-proof their business models while challengers await the starters pistol with their innovative new models.
Achieving SEF status will be significant but is only a rite of passage, not a guarantee of success. We believe the road ahead will be challenging and take a significant and continuous commitment of resources.
Figure 1: Swap Execution Facilities (SEFs) will be the required location for electronic execution of centrally cleared, standardized swaps under Title VII of Dodd-Frank
