Buy Side Preps for SEFs

Terry Flanagan

Institutional investment managers may be more prepared for central clearing of derivatives than is commonly perceived.

At the Financial Technologies Forum’s DerivOps Chicago conference held earlier this week, no hands were raised when about 80 operations officers were asked if they hadn’t yet aligned their Futures Commission Merchant (FCM) and clearing relationships and started to test trades. But there remains lots to do ahead of June 10, when ‘Category 2’ market firms are mandated to start central clearing.

Presenting on connectivity with future Swap Execution Facilities (SEFs), Tradeweb Director of Trade Processing Harold Wright said risks of an operational bottleneck are serious if buy-side firms wait until the last minute to comply with new rules.

Connectivity requirements, implementation time, cost, and structural impediments are primary factors in the transition to central clearing, according to institutional giant BlackRock in a 2011 presentation to the CFTC Technology Advisory Committee.

A gradual, rolling regulatory timeline for buy-side clearing has provided technology vendors, broker-dealers, and other swap-market participants time to address implementation issues along with documentation requirements. Some institutions have moved quicker than others in shifting trades from privately negotiated to electronically executed.

Under Dodd-Frank, dealer liquidity is seen as one of the most important characteristics of a good SEF. Other qualities include a diverse network and number of buy-side participants; broad connectivity to trading systems and integration vendors; links with all major derivative clearing houses; and reporting to swap data repositories (SDRs) and client confirmations.

“Selecting a SEF should be a collaborative decision between traders seeking liquidity and operations professionals focused on efficiency and transparency throughout their workflow,” Wright said at DerivOps Chicago. “The industry does not expect fragmentation of liquidity beyond a few SEFs per asset class, and most of the electronically traded liquidity is already aggregated on incumbent platforms like Tradeweb.”

The financial-services sector faces a number of operational challenges. Clearing certainty, especially on the buy side, has been an important issue. Pre-trade credit-checking protocols are needed to provide assurance that a buy-side firm will have sufficient credit with clearing members to clear trades. This could be facilitated by a clearing house, through a vendor or hub, or at a SEF where the trades are executed. Without it, counterparties are exposed to the possibility of trades failing to clear.

Credit-checking strategies have included development of ‘ping-based’ tools, which provide a drop-down on the trading ticket and allow for a choice of clearing member. When the ticket is sent, the clearing member returns a message to the client to inform them if they have sufficient credit to clear the trade. Latency is a key challenge to this, operations sources said.

Another credit-checking approach is a ‘push-based’ daily upload; in this alternative, clearing members upload credit limits at the start of the trading day, where the information is stored locally. Turn-around time is not a problem, but clearing members may not be comfortable with the inability to manually update credit limits throughout the day.

Tradeweb has implemented a hybrid pre-trade credit checking solution with minimal latency, according to the company. It can check credit at the point of execution while maintaining a client’s information security and confidentiality; the clearing member can upload the credit limit at the start of the trading day with a set tolerance level.

No hub-like facility for the industry is needed, and the risk of losing connectivity to a single source of information is reduced, Tradeweb said.

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