Last year, the over-the-counter swaps market waded its way through regulatory filings to establish an environment that will bring transparency and electronic trading to a market historically dominated by voice trades. With 17 newly minted swaps execution facilities now live, and looming regulatory deadlines that will push more trading to SEFs, 2014 is expected to be the year the industry redesigned by the Dodd-Frank Act begins to really take shape.
As Tabb Group’s Will Rhode puts it, with “the year of compliance” behind us, 2014 will be “the year of competition.”
New business models are already emerging, as sellside firms, interdealer brokers and a variety of new trading platforms seek to define themselves in an uncharted market. Some sellsiders are already live with new service offerings designed to help clients execute swaps trades on SEFs-service offerings that redefine the role firms will play in executing client orders.
“We have long held the view, based primarily on our initial reading of Dodd-Frank, that there would be a significant number of SEFs and the market would become quite fragmented and complex, so we focused on the question of client access to liquidity,” said Paul Hamill, global head of fixed-income agency execution and e-trading at UBS.
As a result, UBS set out to serve as an introductory broker for clients, giving them a single point of access by which to connect to several SEFs. The role has two objectives: By taking on connectivity for clients, the firm enables clients to access markets without having to make additional investments in technology and compliance; and by providing a view of executable prices across several SEFs, the firm can serve as an aggregator of quotes across venues in a fragmented market.
“If you look at other markets, customers do not connect directly to highly regulated markets for the main reason that becoming a direct participant in a highly regulated market is quite involved,” Hamill said, noting that there are record-keeping requirements, auditing requirements and financial reporting requirements in addition to the technological investment required to build and maintain connectivity to several venues.
UBS has adapted its Neo trading platform to serve as the entry point to SEFs for clients and has established connections with several of the SEFs already. It has some clients already live, accessing and executing trades on SEFs through Neo.
“It is what many call an agency-type model. We are no longer taking clients only to the UBS price, but instead we are taking them to the best price and that best price might be someone else’s. What we are providing is technology, compliance and an operational framework,” Hamill said. “Principal trading is still a core part of UBS FI, and this creates an additional service which solved a problem all our derivatives clients face in the new world.”
A DIVIDED LANDSCAPE
The landscape of SEFs is often divided into several categories by market observers, with the SEFs that were formerly interdealer brokers, like ICAP and GFI, making up one category and the platforms that were traditionally used for dealer-to-client trades, like Bloomberg and Tradeweb, making up another. Some observers identify a third category for the new entrants to the market who have histories neither as interdealer brokers nor as dealer-to-client platforms.
The Commodity Futures Trade Commission’s guidelines call for “impartial access” to all SEFs, so theoretically those categories might start to fade away. However, Greenwich Associates’ Kevin McPartland notes that different order styles continue to attract different customer bases. Just as the request-for-quote model of trading is a hallmark of the buyside, some SEFs that were formerly interdealer brokers have voice execution or other features attractive to dealer-to-dealer markets.
“There is basically some latitude to set the market up to attract the user base you are looking for,” McPartland told Traders. “A good comparison is looking at the equities market, where the type of trading on NYSE is different than the trading on Liquidnet.”
UBS began by building connections from its Neo platform to the SEFs that were formerly interdealer brokers, Hamill said, because some clients typically do not have existing relationships with those venues and are eager to access the liquidity and central-limit order book trading protocols they provide.
Meanwhile, UBS is not the only firm seeking to reinvent itself for the new SEF landscape. Credit Suisse and Morgan Stanley reportedly have efforts under way in that vein as well.
In a report on SEF aggregation services conducted early last fall, GreySpark consultancy analyst Saoirse Kennedy initially found that the banks making preparations to offer SEF connectivity and aggregation were in the minority. Much of the industry remained “sluggish and haphazard” in their efforts to adapt to the new landscape. In the past few months, however, that has begun to change, according to Kennedy.
“Banks are beginning to acknowledge that it is not optional to offer SEF connectivity and that connectivity will have to include aggregated connectivity. To maintain the client base, they will need to offer these services,” Kennedy said.
“Dealers are starting to offer a menu of services,” said Tabb Group’s Rhode. “They are saying: I can aggregate prices across a number of SEFs, I can get you access to interdealer broker SEFs with great liquidity, I can act as your introducing broker and stage your order on your behalf, and I can conduct your request for quote into the market, or I can act as your agent and you can say, ‘Here is my order, work it for me and come back with a best price for a fee.'”
STRONGER RELATIONSHIPS
For dealers, the upside is in preserving relationships with clients. “Dealers are basically saying to clients, ‘We are less interested in trying to win each and every transaction. What we are concerned about is when you go out and interact with this market, you are still using our single-dealer platform and we are still a part of your workflow,'” Rhode said.
Meanwhile, just as firms are looking to define their role in the SEF swaps market, the SEFs are trying to define their roles as well.
“From my experience in the industry, I think our customer base never wanted a single interdealer broker because they like competition between venues,” said Chris Ferreri, managing director of ICAP North America. Ferreri envisions two to four SEFs from the interdealer broker community with possibly different groups excelling in different product-for example, one with spread over interest rate swaps and another with options.
Sellside firms are already contacting the company to set up connections to provide aggregation services to clients, Ferreri said.
“I think the ability of firms to bring in non-self-clearing members to broaden the marketplace is an attractive business model to both the swaps clearing members who act as gateways, and to the marketplaces,” Ferreri said. “Do I think we will go from a few dozen members to a few thousand? No. Might we go to 10 or 15 dozen? It’s possible.”
One noticeable change to the new marketplace from ICAP’s perspective is the availability of data through the new swaps data repositories. Dodd-Frank mandated that swaps data be centrally recorded and reported on SDRs, and ICAP has partnered with Clarus Financial Technology to meld its benchmark swaps pricing with Clarus’ SDR View Professional.
“We do a trade and it’s already on the SDR report incredibly fast. It increases transparency, and now everyone can see what the competition is doing,” Ferreri said.
Some of the newer entrants in the swaps market are seeking to differentiate themselves with unique trading models. Tera Exchange offers both an order book and the RFQ method of trading, as well as a third, patent pending “directed order” model that marries the two.
Essentially, directed orders operate similar to RFQs, in that they allow for a market participant to specify one or more recipients of their order. However, directed orders are distinct from traditional RFQs in that the requester selects a desired price and the directed order trades only within the CLOB and is accessing the reserved liquidity of the market maker.
“We are a central-limit order book platform, but we acknowledge that the RFQ will always be around for certain products, as well as for portfolio termination and compression. Our directed order marries the two and is a significant differentiator for us,” said Phil Boeding, senior vice president at Tera Exchange.
NEW DAYS STILL
While it may seem that major changes are already in place, it’s worth noting that these are still early days. While interdealer brokers generally have transformed into SEFs and therefore have all their liquidity trading on SEFs, on the dealer-to-client side many buyside firms are holding back from SEF trading. One exception among the traditionally dealer-to-client SEFs that has started to see significant SEF trading volumes is Bloomberg.
“We have been pleased with the participation and volumes executed on Bloomberg’s SEF. All the major liquidity providers are contributing to our platform and as of early January, $680 billion in cross-asset volume has been traded,” said Ben Macdonald, president of Bloomberg’s SEF. Macdonald said more than 300 global firms have used Bloomberg’s SEF and that users have comprised both existing customers of the company’s multi-asset trading platforms and new customers preparing for regulatory mandates.
In particular, Bloomberg has seen strong volumes in credit instruments. During the early weeks in December leading up to the holiday weeks of Christmas and New Year’s, Bloomberg’s weekly totals in credit instruments made up more than half the total across all SEFs, according to data compiled and published by Tod Skarecky of Clarus Financial Technology.
Skarecky, who heads the U.S. business of Clarus Financial Technology, publishes a weekly blog of SEF data. Comparing his SEF data with data from Clarus Financial Technology’s SDR View application, which offers a granular view of the full spectrum of OTC swaps data, shows how much trading has yet to move to SEFs. “What we are finding is that SEF data accounts for between a third and 40 percent of the total OTC swaps transactions. It’s definitely not the lion’s share,” Skarecky said, adding that the interdealer broker SEFs make up most of that SEF trading volume. Add to that the fact that SEFs launched during a government shutdown followed by a holiday season, and the view of trading has been atypical to say the least.
Over the course of the year, though, big changes are expected. “2013 was about moving to clearing, and that didn’t really change the way traders interact. 2014 will be a major change in the way traders interact,” said McPartland of Greenwich Associates. “There is a whole lot more data, access to markets will be easier, we might even see new entrants to the space. This is the year that all the changes will start to have a huge impact on trading.”
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