Clobbered by CLOBs

Terry Flanagan

Markets seek clarity from CFTC on central limit order books for swaps execution venues.

To CLOB or not to CLOB, that is the question being asked of and by regulators.

The applicability of central limit order books (CLOBs) to swaps trading is a hotly-debated topic among market participants as the SEC and CFTC wade through the convoluted Dodd-Frank rulemaking and implementation process.

Operators of trading venues for OTC swaps want institutional investors to have the choice of executing block trades via an auction-based, request for quote (RFQ) system or a CLOB-based system.

They say institutional investors should have freedom to choice method of execution.

“We are not opposed to CLOBs,” Rick McVey, CEO of MarketAxess, told Markets Media. “We have offered them in the past, and may offer them again in the future. However, we don’t believe that an auction-based system should be required to offer CLOBs.”

“The determination on which trading protocols should be employed should be made by clients, not by highly prescriptive rules,” McVey said.

The CFTC’s proposed rules require SEFs to allow market participants to leave executable bids or offers that can be seen by the entire marketplace, i.e., a CLOB.

“That means that any market participant – a bank or a nonbank – a corporation or a financial institution – can choose if they want to enter into a swap against a resting bid or offer,” CFTC chairman Gary Gensler said in October.

Although the CFTC may have intended that its proposed rule relating to RFQ platforms would not require a SEF that operates an RFQ system to have a CLOB, the text of the rule is not clear.

In the SEC’s proposed rule, if a securities-based SEF operates a CLOB and a separate RFQ mechanism, then any trade would need to interact with existing interest on the central limit order book at the same or better price before interacting with interest on the RFQ platform.

Market participants are concerned that if a block trade were required to interact with other trading interest on an SB SEF, there might not be  enough liquidity on the SB SEF to execute the entire block trade, leaving a portion of the block trade unexecuted.

Not having a large trade filled, or having it filled at a disadvantageous price as a result of having to enter into more than one trade as part of the execution process, could harm investment performance.

Consequently, market participants have urged exceptions for the handling of block trades, including the ability to negotiate and execute block trades without having to interact with resting orders.

MarketAxess earlier this year launched an enhanced institutional credit trading system that includes significant additional functionality for credit default swap (CDS) trading. With this release, MarketAxess has much of the core trading technology that complies with the proposed rules and allows clients maximum flexibility in how they wish to trade CDS – both indexes and single-names.

An analysis of CDS transactions published by the Federal Reserve Bank of New York shows that the most active of single-name CDS contracts traded a little over 20 times a day, and some index CDS contracts traded over 100 times a day. However, the majority of single name CDS contracts trade less than once a day, but in very large sizes.

Very liquid instruments migrate over time to CLOBs, but less liquid instruments tend to trade better in a request-for-quote system.

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