There is ample uncertainty surrounding the launch of swap execution facilities, but when the rules and protocols are clarified and more market participants are comfortable transacting on up-and-running SEFs, end users’ focus will be on how and where to trade most efficiently.

“Best execution is our primary concern,” said David Long, chief investment officer for asset/liability management, derivatives, and fixed income at the $47 billion Healthcare of Ontario Pension Plan. “You need to route your order to the SEF that has the most advantageous price for a particular kind of contract. But do you have the technology to efficiently execute across a variety of SEFs, and how do you decide which of the venues to route to?”

It’s reasonable to assume that SEF liquidity will need some time to pool. Some SEFs such as Tradeweb’s went live and operational as of Oct. 2, but earlier this week the U.S. Commodity Futures Trading Commission extended deadlines to meet certain requirements, and the CFTC has since essentially closed due to a government shutdown.

Traders of interest-rate swaps and credit-default swaps are looking beyond the near-term stops and starts to the seemingly inevitable day when SEFs will be as entrenched as exchanges are for stock traders. For now, it’s unclear how or even if the redrawn landscape will result in improved trading versus the predecessor OTC system.

“We’re not convinced that any particular SEF will represent a bona fide value-add in how we execute orders,” Long told Markets Media. “Obviously we’ll comply with whatever regulations are out there, but liquidity is going to be an issue. If you’re mandated to trade on one or more SEFs, and the liquidity on the other side of your transaction isn’t there, it’s going to be a challenge.”

One issue, at least at the outset, will be the number of SEFs. Traders in U.S. equities and options lament fragmentation in their markets, which have 13 and 12 exchanges, respectively. Since late July, the CFTC has approved 17 temporary SEF registrations, according to its website. Approved SEF operators include Tradeweb, Thomson Reuters, ICAP, Tradition, 360 Trading Networks, TruEX, IntercontinentalExchange, Javelin, BGC Derivative Markets, TeraExchange, SwapEx, GFI, MarketAxess, and Bloomberg.

Expand, Then Winnow

There are more SEF applicants in the pipeline, so the field is expected to expand in the near term. Still, market participants say not all SEFs will have staying power, and the field will inevitably consolidate as the business moves along the industry life-cycle curve. “It’s very likely that only three to five SEFs in each asset class will survive,” said Sam Priyadarshi, head of fixed income derivatives at Vanguard. “Market participants want liquidity. If liquidity is thin on an SEF they will not trade there.”

“Because the SEF space is going to be potentially fragmented, trying to aggregate liquidity across all SEFs when you’re trying to execute an order can be a challenge,” said Long of HOOPP. “Obviously you’re going to want to have connectivity to as many SEFs as possible because that will give you access to more liquidity. But it’s still a bit of an abstract space — I’ve seen and operated on specific kinds of marketplaces, but I haven’t executed orders on a SEF yet. So I’m trying to imagine what it’s going to be like, rather than talking from practical experience.”

Long noted the increased transparency inherent to a centralized SEF framework can potentially impair liquidity in some of the more thinly traded swaps. Liquidity-aggregating technology can help, but the complexity of the swaps market vis-a-vis other markets limits its efficacy.

“In today’s OTC world, we can do a transaction with a counterparty, and only the two of us know about it. Because the information is tightly held, one or both sides can hedge in the market without having to disclose to the market the need to do so,” he explained. “But in a SEF world, with broader disclosure about trade volumes and trade levels, it could be challenging to find liquidity in large sizes or in certain contracts, because market makers will be reluctant to enter into the trades. So the rules around disclosure ultimately may require some calibration long-term.”

“For some contracts that are already very liquid — for example the plain-vanilla five-year interest-rate swap — I can’t see how trading on a SEF and being public about it is going to inhibit liquidity,” Long continued. “But it will be challenging for the illiquid contracts that may be customized and specialized.”

The new SEF regime may bring about “unintended and unpredictable consequences to spreads and liquidity size,” especially given that swap contracts are generally larger and trade less frequently than other markets such as futures, consultancy PwC said in a June report. But there may be a constructive longer-term effect on liquidity.

“Over time, the accumulation of a reliable time series of actual transaction prices may be a valuable asset to market participants and central clearinghouses,” the report said.