Transition to swap trading looks messy, SEF report suggests: By Dominic Hobson

Operational RiskRegulation
02 Oct, 2012

The accelerating transition of swaps to a new world of centralised clearing has obscured the concomitant regulatory push towards electronic trading. Yet the challenges of clearing and trading are inextricably linked: a tradeable swap is, by regulatory definition, a clearable one.

In other words, shifting swap trading on to exchanges or so-called Swap Execution Facilities (SEFs) is central to the ambitions of the Dodd Frank Act. Their European equivalents – Multi-lateral Trading Facilities (MTFs) or Organised Trading Facilities (OTFs) – are equally important to the long term success of the European Market infrastructure Regulation (EMIR).

For fund managers pondering electronic swap trading, the longer term prospect is pleasing.  Up to now, they have traded swaps almost entirely through voice-based dealers, which have controlled pricing and access to liquidity. They will be disintermediated by a variety of platforms offering access to credit, rates, FX, equity and commodities swaps at openly published prices.

Eventually, liquidity in the full a range of tradeable swaps will be available on a limited number of platforms, but the transition could be messy.  On both sides of the Atlantic, complete and detailed regulations on swap trading – especially whether it will be quote-driven or order-driven - are still awaited. Differences also persist between the US approach (set by Dodd Frank) and the European plans (set by EMIR).

But the broad outlines of what regulators want are clear enough.  First, full post-trade transparency, with details of trades reported to trade repositories. Secondly, intermediation of counter-party credit risk via central counterparty clearing house (CCPs). Thirdly, pre-trade transparency, with prices made openly available to all market participants.

It is on this last point that the third in the series of papers on SEFs, OTFS and MTFs published by London and Hong Kong-based consultants Greyspark– the first explored trading venues, and the second ways of connecting to those venues – dwells at length. The essential issues are how the buy-side can access liquidity cheaply and effectively, and whether regulators will succeed in imposing a superior (in terms of transparency) order-driven model on an industry which prefers to stick with quote-driven trading.

Order-driven trading better meets the criterion of transparency because all market participants will be able to see all prices at all different sizes – ideally, at firm prices - whereas a request for a quote-driven system will see prices vary sharply by client. Though there is a perception that order-driven trading will be mandatory, Greyspark insists this is not yet the case, and that sell-side market participants rather than regulators are at present driving the choice.

That quote-driven trading has survived regulatory preferences is something of a triumph for lobbying by swap dealers. But it also reflects the higher priority attached by regulators to clearing than trading. Their ultimate lack of insistence on order-driven trading is already emboldening dealers to argue that quote-driven trading by multiple swap dealers keeps prices more honest, and that order-driven platforms will trade at wide bid-offer spreads.

In reality, only the biggest funds will be capable of continuing to extract fine prices from dealers. Current trading platforms that bring together brokers and fund managers, including Bloomberg and TradeWeb, tend to be quote-driven – and prices do vary by the size of the client. For others, even execution is far from automatic. Statistics on how successful sell-side providers are in fulfilling orders can and doubtless will be published, but inevitably large fund managers will still be offered the better prices.

Here, an element of Stockholm Syndrome will also be at work. Fund managers of all shapes and sizes and strategies tend to believe that in any asset class they can obtain better prices from the swap dealers they know, love and use. This will almost certainly limit the impact of order-driven trading on the development of the swaps markets, at least initially.

A further inhibitor to breaking free of dealers will be the degree of fragmentation. The first of the three Greyspark studies identified no less than 52 potential SEFs, MTFs and OTFs, of which Bloomberg and Tradeweb are the best-known, alongside CME, Currenex, FXAll, ICAP, ICE, Newedge and Thomson Reuters.

Even with most of the business concentrated at a sub-set of a dozen or so platforms, the Greyspark report clearly indicated that liquidity will be highly fragmented at the outset. Not every platform will trade every asset class, many will trade only a single type of swap, and a number of less liquid swaps contracts will continue to trade OTC for the foreseeable future.

To access such a fragmented marketplace, fund managers will have to connect to multiple sources of liquidity. When Greyspark assessed the connectivity options – most will naturally make use of the established FIX and FpML messaging protocols – it identified a mass of issues to address beyond the obvious (Buy or build? Which vendor?), including trade and pre-trade technology, post-trade reporting and clearing, and management of reference data.

Nor are swap trading platforms being launched into virgin territory. A market dominated by voice-based swap dealers will give way to open electronic trading platforms only slowly, as the incumbents are forced to adapt their business models.  Many will simply swap their telephones for electronic execution platforms, and offer access to liquidity other than their own. In other words, many fund managers will use dealers to access trading venues as well as the traditional dealer sources of liquidity, though doubts will grow about how many prices the buy-side is really seeing.

Single dealer platforms may survive, and multi-dealer trading platforms akin to those now available in the FX markets may emerge – Currenex and FXAll, for example, are already among the likely SEF-OTF-MTF providers  -  especially if they can prove to regulators and clients that they are offering access to all sources or achieving “best execution” at firm prices.

If it follows the pattern set by the cash markets, electronic swap trading will gradually come to be characterised by higher volumes and lower ticket sizes than the present system. This will appeal from the outset to high frequency traders and statistical arbitrage funds ready to exploit the new forms of liquidity. But all fund managers of a certain size will eventually want direct market access (DMA).

Although the sell-side will continue to offer connectivity to the buy-side, through single- and multi-dealer platforms, DMA does threaten dealers with disintermediation. This will further erode the margins of swap dealers already likely to be affected by loss of order flow, by decisively loosening their control of access to liquidity.  It will have less effect on inter-dealer brokers, because they are bound to simply morph their existing trading platforms into SEFs or OTFs or MTFs.

As a result, the relative importance of clearing fees as a source of revenue for swap dealers will increase. This will encourage dealers to offer clients access to all SEFs and every CCP, and  look to get paid by incorporating a conveniently accessible set of clearing and collateral management services. Execution business may, in effect, become a means of capturing clearing revenue.

For fund managers, the consequent savings in execution costs will be offset by higher costs in clearing and especially collateral management – where the  need to pay variation margin in cash will force them either to invest a larger proportion of their portfolios in cash, or repo securities to raise the necessary cash.