Six months after the made-available-to-trade deadline that was viewed as the starting gun for trading on swaps execution facilities (SEFs), some market players say the most noteworthy pattern that has emerged is a return to familiar routines. Dealer-to-client trading has remained with providers who traditionally served that model, and dealer-to-dealer trading has resumed at the inter-dealer brokers that have long competed for that business.
Yet while the market looks to return to the patterns it is accustomed to, there is growing interest from potential new participants in new opportunities SEFs might provide.
We are in the process of talking with and onboarding with SEFs, said Isaac Chang, global head of fixed income at KCG, who noted that KCG is not trading on SEF currently but plans to do so. What interests us is that interest rate swaps have a fundamental underpinning that is very close to a lot of the instruments we trade. We trade euro dollar futures, Treasury futures, cash U.S. Treasury bonds – a lot of the same factors that affect those markets affect interest rate swaps, but the market has always been closed to us before the advent of central clearing. Now with SEFs, execution is moving electronic as well. The firm is evaluating instruments but currently focusing on market agreed coupon (MAC) interest rate swaps and credit index swaps because of their more standardized futures-like structures.
KCG is not the only one knocking on the door. Citadel Securities confirmed in an email that it has done a SEF trade and that it is building a market-making business in the space, but declined to comment beyond that.
Quantitative Brokers, another potential entrant, remains noncommittal but is watching the space with interest. We think its going to go but it hasnt gone yet, said Robert Almgren, president and co-founder, who noted that the company is waiting for more liquidity and consolidation of existing SEFs. We dont want to build out to something that is going to vanish, Almgren said.
Follow the Leaders
The first entrants are early adopters, and may be too few in number to represent a change in the tide, but they are noteworthy in that they are operating in a market that was once off-limits to them for a variety of reasons.
I think think there are many potential participants who have been waiting on the sidelines for some time, said Paul Hamill, global head of FX, rates and credit execution services at UBS. Using its Neo platform, UBS serves as an agency or introductory broker, providing stream-based API access to the different SEFs including post-trade API, aggregation and other services. What we have found in our outreach is a huge amount of interest from non-traditional players in the market, and a fairly significant lack of awareness as to where the market really is in terms of depth, liquidity, central limit order book trading and access options overall.
Some of the most conservative views on new entrants into the marketplace come from interdealer broker SEFs themselves, who stand to benefit from new volumes. That might be an example of catering to existing dealer clients, which overwhelmingly prefer voice RFQ models that are least disruptive to their existing business models. For IDBs, SEFs are a medium-term play, said Aite Group senior analyst David B. Weiss. They are beholden to the dealers, and the dealers know that in two years the market will change, but it hasnt gotten there yet.
A representative of one interdealer broker who asked to remain anonymous said that the firm is at the stage of educating potential clients about the SEF and its trading process. There has been some interest, but I think its fair to say that the market seems to have migrated to where it was prior to impartial access in terms of customer dealing where they are accustomed to dealing, the representative said. Firms that were on dealer-to-client platforms are on dealer-to-client SEFs; firms that were on dealer-to-dealer platforms are on dealer-to-dealer SEFs. Is there some overlap? I think there will be, but I dont think its to the extent that some are trying to characterize it.
According to an ICAP press release issued in the beginning of August, July marked the third consecutive month of record volumes on i-Swap, the electronic central limit-order-book arm of ICAPs SEF. U.S. dollar interest rate swaps volume hit 859 trades on i-Swap in July, with a notional value of $41 billion, representing 40 percent of all U.S. dollar interest rate swap trades at ICAP. The SEF also has a voice-based request-for-quote modeled execution service. Central limit order-book models appeal to newer participants, but the i-Swap volume data does not indicate the type of firms participating in the trades.
Jeffrey Hogan, managing director, business development at interdealer broker BGC Partners, noted that several key rules related to SEF execution remain outstanding. He added that the unfinished nature of regulatory mandates may be compelling some market players to take a cautious and patient approach toward changing trading styles or venues.
The vast majority of products that are subject to transaction requirements on SEFs by U.S. persons are not yet fully electronic and are not being executed on central limit order books, Hogan said.
Hogan noted that the U.S. Dollar Interest Rate swap market in the swap dealer space remains at least 70 percent voice, and globally the Euro Interest Rate Swap is 85 percent voice for dealers. Credit markets are significantly more electronic merely because the relevant indices are fewer in number, and these electronic trades are also taking place largely outside the CLOB but via other electronic means, he said. The changes will come, but it will take time. Were still very early in the timeline of SEF influences.
The Catalysts
Meanwhile, though some impediments to increased electronic trading and a broadening of the market to new participants remain, there are also catalysts pushing the market more electronic as well. Among them is central clearing.
We are seeing some customers who are choosing to trade on SEFs whilst not obligated to do so due to the benefits of central clearing in controlling counterparty risk, said BCGs Hogan. There are non-U.S. persons who feel accessing SEF structured central clearing confers advantages.
KCGs Chang views central clearing as an equalizer that enables smaller firms to compete. In a bilateral world, if you are worried about credit exposure, 10, 20, 30 years out, you are going to go with the too-big-to-fail institutions because you know they are going to be around. If anything happens to them, the government is likely to bail them out, he said. Central clearing essentially levels the playing field. At the end of the day, everyones exposure is in the clearinghouse. For firms like us, it allows us to provide liquidity to the swaps market and eliminate the counterparty exposure.
OTHER FACTORS
Other factors now attracting newcomers to OTC swaps include transparency and central limit order book trading. We have an explosion of data in this market that never existed before, and I think that will be a major factor in bringing new participants to the market, says UBSs Hamill.
For Quantitative Brokers, the central limit order-book model, with the anonymity it offers, is an absolute prerequisite to trading. For us, it would have to be a central limit order book. And if there are multiple venues and multiple central limit order books, we can do smart order routing, Almgren said. In an ideal scenario, Almgren added, the number of SEFs would consolidate down to a handful, with healthy competition among them. We would trade on all of them, track liquidity on all of them and route orders to whichever one is most favorable. Its how we add value.
Some see a move toward more automated trading strategies as an inevitable path for the market. Once some of the kinks get worked out and liquidity really starts to grow and more tenors start to become increasingly more liquid, then we can really start seeing some dynamic arbitrage-like trading, said Sol Steinberg, founding principal of research firm OTC Partners.
As you get more electronification, greater transparency, and on the back of that more data, firms that are really good at using speed to promote client franchises and manage risk more effectively are going to gravitate to that market, added Anthony Perrotta, head of fixed income trading at Tabb Group.
In the end, with SEFs, as with any market, liquidity will likely be the ultimate catalyst. We have seen order books get as tight as an eighth of a basis point for liquid points, said UBSs Hamill. If you get a lot tighter than that, then its a catalyst where pretty much anyone says this is where I can get by best execution.
