06.11.2013
By Terry Flanagan

SEF Rules Raise Liquidity Challenges

With the ink hardly dry on the Commodity Futures Trading Commission’s final rules for swap execution facilities, concerns exist that a proliferation of SEFs, each competing for a slice of the OTC swap business, will lead to a fragmentation of liquidity such as has occurred in the equity markets and other asset classes.

The immediate concern revolves around the “made available to trade” rule or MAT for short, which states that a swap that is subject to a mandatory clearing determination by the CFTC must be traded on a DCM or SEF, except where no DCM or SEF has made the swap “available to trade.”

The MAT rule sets forth the factors a SEF or DCM must consider in determining whether a particular swap should be made available to trade, such as whether there are ready and willing buyers and sellers; the frequency or size of transactions; the trading volume; the number and types of market participants; the bid/ask spread; or the usual number of resting firm or indicative bids and offers.

Once a swap is approved or deemed certified as “available to trade,” all other DCMs and SEFs that list or offer that swap for trading must comply with the trade execution requirements of the applicable SEF or DCM rule.

The incentive for a DCM or SEF to make MAT determinations are underscored by the history of central execution markets, which reflects that a significant, and perhaps insurmountable, first-mover advantage exists for the trading facility that first brings a given product to market.

“SEFs are now incentivized to find reasons to list instruments and declare them, ‘made available to trade,’” said Daniel Parker, vice president of solutions consulting at SunGard’s capital markets business, in a blog posting. “This race to the bottom will likely result in mass SEF consolidation, but before that, we will embark on one of the greatest shifts of market-inspired transparency aggregation in history.”

CME reported a substantial increase in cleared OTC derivatives in March as a result of the first phase of mandatory clearing. For the CME, cleared OTC IRS volume (notional value) was $488.9 billion in March, up from $13.7 billion in the prior month. Since launching in October 2010, total IRS volume cleared is $3.3trillion as of May 2013.

At ICE, cleared OTC CDS volume (notional value) was approximately $1 trillion in March. Through May 2013, total CDS cleared is $41 trillion.

“We expect broader regulation of swaps-market participants and dealers to drive costs higher over the next few years as OTC activity migrates to central clearing through multiple CCPs both in the U.S. and overseas,” said Tara Kriss, senior director of financial institutions at Fitch Ratings, in a report.

Regulations will result in higher reporting and infrastructure-related costs tied to this migration, in addition to new collateral and margining requirements.

“Now that the purpose of the SEF rules has been articulated, the resulting message invites ISVs to embark on the next big thing; specifically, swap processing services such as transparency aggregation, market visibility, or analytics such as portfolio compression or risk mitigation techniques,” said SunGard’s Parker. “Each component is an integral part of a successfully functioning swaps market.

The “next big thing” never comes without its challenges. “From a delivery perspective, in this post-SEF environment, it is important to be mindful of separating execution capabilities from a processing services offering – which is the bright-line distinction between leveraging facility execution and being an execution facility,” Parker said.

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