OTC Marketplace Takes Shape

Terry Flanagan

The challenges of melding together the exchange-traded model and the traditional voice-traded OTC derivatives model have moved from the theoretical to the practical as swap execution facilities get underway.

SEFs have been in operation since last fall, but trading on them only has been mandatory since February 18.

The final SEF regulations allow a SEF to utilize “any means of interstate commerce” in providing execution (i.e., an order book or an RFQ System that operates in conjunction with an order book).

This leaves open the question of whether the term “order book” is the same as central limit order book (CLOB). Adapting a CLOB to trading on SEFs presents significant obstacles. The idea of trading swaps in a CLOB, which essentially alters relationship with counterparties, is a somewhat new concept.

“CLOBs do get a lot of discussion with market participants,” said Chris Amen, head of U. S. institutional rates markets at Tradeweb. “A driver of that dialogue is uncertainty surrounding information leakage and market impact when our clients execute trades electronically. We’re looking at a number of aspects of the swap market that might support large scale participation on CLOBs, but it’s still very early in the adoption of derivatives e-trading.”

Tradeweb operates a fully disclosed marketplace that offers multiple trading protocols, including order book trading. Within that marketplace, its request for quote (RFQ) protocol continues to be the most popular with clients to execute trades electronically as they migrate their swaps trading from voice to SEFs.

“We also have an order book protocol, which is different than a CLOB, where a client can post fully disclosed orders, including company name, notional and limit rate on a ‘Bulletin Board’ of orders that market participants can see and aggress on to execute trades electronically,” Amen said.

Futures commission merchants (FCMs) play a crucial role in not only connecting their clients to SEFs and DCMs (designated contract markets) but in ensuring that clients do not exceed their approved credit risk limits. This need has been fulfilled by post-trade service providers such as Markit and Traiana, as well as by the SEFs themselves.

“In order to guarantee that there would be the margin for the buy side to do the trade every time the SEF would have to ping out to and have the connections to pretty much every single FCM in the world or where the buy side sides have a relationship with,” said Sassan Danesh, partner at Etrading Software, a financial technology consultancy. “And that model has meant that you would have to have the Traianas and the Markits coming in to provide solutions so that it’s much more of a hub and spoke.”

Tradeweb worked proactively with the FCMs, and was the first to launch pre-trade credit check components for its RFQ system, said Amen.

“FCMs have become much more comfortable around pre-trade counterparty credit,” he said. “Clients get approval notifications immediately from the FCM, and the trading process that follows is seamless. We’re working to determine how that pre-trade credit checking process can translate quickly into essentially, an order book. We think FCM’s will get there in the near future, but likely with a select number of accounts. There’s a lot still yet to be determined.”

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