SEFs: The Road Ahead

Terry Flanagan

For swap execution facilities, volumes are expected to continue trending higher, but there remain some question marks pertaining to the framework of the business as set forth by the U.S. Commodity Futures Trading Commission.

As participants and observers of the SEF space await a clearing of the regulatory smoke, SEFs themselves are moving ahead with initiatives to attract order flow.

“We’re going to see further innovation in products and services that are offered, along with more specialization in liquidity formation by product or asset class,” said Matthew Kulkin, principal at Washington, D.C.-based Squire Patton Boggs.

In general, institutional traders have acclimated to the sea change of buying and selling interest rate swaps and credit default swaps on SEFs rather than the primary pre-Dodd-Frank mechanism of private telephone negotiation. That was no easy task, as market participants had to first, understand the new rules and second, build out the necessary infrastructure to comply.

“We believe we’ve come through that period, and people are feeling better about trading electronically on SEFs,” said Chris Amen, head of U.S. institutional rates markets at Tradeweb Markets, which operates two SEFs. “You can see that in our volumes. We’ve also had a number of conversations with institutional clients who are feeling more comfortable with where they are and are excited about the road ahead.”

That road may feature some regulatory repaving. CFTC Commissioner Chris Giancarlo turned heads on Jan. 29 when he published a whitepaper criticizing how the CFTC has implemented the execution of swaps trading on regulated platforms, and proposing “a comprehensive, cohesive and flexible alternative that better aligns with swaps market dynamics and is more true to congressional intent.”

Matthew Kulkin, Squire Patton

Matthew Kulkin, Squire Patton

Specifically, Giancarlo recommends that the broadest range of U.S. swaps trading activity be subject to CFTC oversight, and that artificial segmentation of swaps trading be removed and all CFTC swaps trading be regulated in a holistic fashion. Giancarlo was sworn in as commissioner in June 2014, eight months after SEF trading commenced.

The whitepaper “is a bit of an X factor, as it implies there may be changes in the future,” said a sell-side executive, who spoke on condition of anonymity.

Swaps traders are watching the SEF landscape for how competition among operators plays out. About two dozen SEFs have been approved by the CFTC, though only a half dozen are transacting meaningful volumes, led by Bloomberg, ICAP and Tradeweb.

“Our hope is that there is enough healthy competition in the space over time to reduce the costs of access and increase the options of access for end users like ourselves,” said Boris Liberman, vice president and associate general counsel of AQR Capital Management.

“The value traded on SEFs will definitely increase — how much it increases will depend on how the regulation ends up, technology, and how the existing SEFs will prove themselves as more and more instruments are mandated to be cleared through their pipes,” Liberman said. “Technology is obviously important, but also the idea of trading electronically is something that needs to be more ingrained in the psyche of some market participants…At AQR, we embrace electronic anonymous markets as we feel they help reduce the friction and costs of trading, which ultimately helps our clients.”

Lower costs and better integration between the buy-side and sell-side players in the SEF space should increase volumes, according to Liberman, “as we have witnessed in other markets that have made the same transition.”

SEFs can continue to increase business incrementally, but regulatory change is needed for end-user SEF adoption to reach “critical mass”, according to Nicola White, global head of rates for Morgan Stanley’s electronic markets business. “In order to give SEFs a chance to compete, the issues must be resolved in a way that creates a level playing field with futures,” she said.

Featured image via magann/Dollar Photo Club

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