Easing the Transition to SEFs03.20.2015 By Terry Flanagan
Although the usage of swap execution facilities for some transactions is mandated by law, their uptake among market participants has been limited thus far due to the ‘stickiness’ of the bilateral model, in which banks and interdealer brokers handled the intricacies of OTC swap transactions.
SEFs are up and running with the more plain-vanilla swaps products, but there is only so much standardization that can be achieved in complex financial instruments.
“There are still trades that happen off SEFs that are allowed to happen off SEFs,” said Matt Battistella, director, Americas FICC electronic sales at Bank of America Merrill Lynch. “There are reasons why it might not be easy for those trades to execute on SEFs, perhaps because they are bespoke in nature.”
In interest rate swaps, there are many different permutations that lead to the creation of many unique instruments. “It isn’t like a single liquid security or company stock, where there are a large number of willing buyers and sellers at any given moment,” Battistella said. “There are a consistent number of natural buyers and sellers in the market place for say, IBM shares; in the universe of swap instruments, this is not always the case.”
At the same time, there are a finite number of market participants who trade swaps, which tend to be “sophisticated products traded by sophisticated clients,” Battistella said. “In the context of the global marketplace, there weren’t a huge number of market participants who would trade these sorts of instruments before SEFs, and there aren’t necessarily more now. So if you look at the universe of willing buyers and sellers of these sorts of instruments, it’s not that large.”
As capital constraints continue to impact banks and their ability to facilitate prices, clients are looking for alternative means to execute their orders, said Rana Chammaa, head of eDistribution for rates & credit, Americas, at UBS.
“They see the benefit in the all-to-all [model], but some pain points persist,” Chammaa said. “In many cases it depends on the type of client that you’re talking to. If we talk to global macro hedge funds, they tend to be more receptive to order book trading as familiarity with trading more electronic asset classes like futures is greater.”
Further guidance regarding CLOB [central limit order book] anonymity from the CFTC “will be a big proponent and catalyst to further adoption of central limit order book trading, and that’s top of the list for us over the next few months,” Chammaa said.
Noted Battistella, “In terms of impediments that exist, there are some legal, operational, and technical obstacles to overcome before a participant can trade on a SEF. But because these clients are sophisticated, they have the resources to on-board themselves to a SEF — maybe not on day one, but over time.”
Compared to other asset classes, electronic trading of OTC derivatives is still in its infancy.
“If someone came from an FX or equities background and looked at the rates market and how it operated, it would come across as quite antiquated,” said Declan Graham, head of business development, FRC Execution Services at UBS. “In essence, we’re starting to move away from the ‘old-school’ model of trading, where one physically calls somebody and they call someone else, which has always struck me as a rather inefficient way to trade.”
In Europe, trading on SEF-like venues won’t become mandatory until MiFID II is implemented in 2017, but market participants are looking closely at the U.S. for clues as to how electronic OTC trading will play out.
“The fact that SEFS have this all-to-all construct is something that certain European clients are very excited about,” said Graham. “Right now, MTFs as they exist in Europe don’t have the same impartial access requirements, meaning that vested interests can dictate how an MTF will operate. On the other hand, a SEF won’t have the same restrictions. European clients see SEFs as a way of leveling the playing field.”
Harmonization of rules between the U.S. and Europe would ease the transition.
“When we talk to heads of trading at various European firms, they are hopeful that the regulators between Europe and the US will be able to correct the equivalency rules,” Graham said. “As a result, by trading on SEFs a client would be compliant with MiFID II and conversely by trading on a MiFID II regulated trading venue they would also meet the SEF obligations.”
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