SWAP EXECUTION FACILITIES: a catalyst for OTC market change?
Could mandatory electronic execution of over-the-counter (OTC) derivatives, stemming from the 2009 G20 Pittsburgh Summit, act as the catalyst in spawning new business models? Jim Myers, Kimon Mikroulis and Paul Gibson discuss the impact of mandatory electronic execution for certain OTC products under the most advanced of these electronic mandates, Dodd-Frankís swap execution facilities (SEF). As the OTC markets are entering a phase of rapid evolution, concepts that were originally created in the exchange-traded world, such as sponsored access, agency execution and general price aggregation, are emerging as critical issues to be addressed by OTC market participants.
The Dodd-Frank Act created SEFs to facilitate transparency and impartial access in the OTC derivatives markets. The fundamental purpose of a SEF is to connect market participants. In doing so, SEFs perform a variety of functions, including price discovery, order matching, unique swap identifier (USI) generation, submission of trades to the designated central counterparty (CCP) and trade reporting to swap data repositories (SDRs).
SEF trading and the “electronification” of the OTC marketplace are still in their infancy. Since the publication of the final SEF rules in March 2013 by the US Commodity Futures Trading Commission (CFTC), many items have been identified as key challenges to overcome for newly minted SEFs and SEF market participants. These issues include trade certainty, credit checking, impartial access, block trading and bunched orders. Additionally, there has been endless debate about which firms will emerge as either winners or losers in the newly created SEF space.1 With mandatory SEF trading finally a reality for US participants and their counterparties, both new and old challenges are directly affecting the evolution of the industry (see Figure 1).
Ensuring Pre-trade Clearing Certainty
The industry is struggling to implement a consistent and effective model for pre-trade clearing certainty and credit checking on SEFs. Currently, major clearing houses, like the Chicago Mercantile Exchange (CME), IntercontinentalExchange (ICE) and London Clearing House (LCH), have indicated that they expect the futures commission merchantís (FCMís) credit check prior to order entry at the SEF to be a sufficient guarantee that their clients do not exceed their assigned credit limits. As such, CCPs will automatically accept a SEF trade for clearing upon arrival. This underscores the importance of the pre-trade credit check in the new SEF trading process flow.
Most SEFs today are working with a ìpushî method for credit checking, where an FCM pushes a limit to a specific SEF. Several disadvantages inherent in the push method include less flexibility for clients (limit is pushed to specific SEFs), less dynamic limit control for FCMs (pushed limit is out of their control once sent) and more responsibility on SEFs in the form of updating the pushed limits as quickly as possible.
Many market participants believe that a better long-term solution is to utilize a ìpingî model, through which an FCM is able to actively manage customer limits by responding to a ping from a SEF with a limit token, essentially authorizing the trade. This requires greater technology investment for both SEFs and FCMs. In addition to added connectivity with entities across regions and time zones, the FCM community must have systems in place to respond to a ping in real-time. Most likely, this will be achieved by enhancing current systems to respond to the ping whether the FCM’s client has enough risk, margin or credit limit available for a specific transaction. Further complicating the pre-trade limit checking obligation is the lack of a clear communication standard to help facilitate the flow of information from FCM to SEF, while also keeping asset managers appraised of their current limits by SEF, CCP, currency, product, etc.
Centralized limit checking has emerged as a way for FCMs and clients to ensure limits are managed effectively. With centralized limits, FCMs need to connect with only one central hub instead of maintaining multiple connections with different SEFs. This model has not, however, resolved the latency issues inherent in the ping model; nor has it impacted the rigidity of the push model. Additionally, there has been some hesitancy from the FCM community to provide the vast amount of risk management data required to a third-party hub. FCMs view their proprietary risk methodologies as key pieces of intellectual property and view the data provided to these hubs as a potential intrusion into the inner workings of their risk systems.
Potential for Regulatory Shopping
Perhaps more concerning in the short term is the fact that the United States has experienced what amounts to a first-mover disadvantage. By establishing regulations around the execution of OTC trades and the resulting non-harmonization of global regulations, many OTC market participants with the ability to remove themselves from the CFTCís oversight have done so. Liquidity pools have shifted toward European dealers as global banks look to avoid SEF rules.
The CFTCís mandates have given rise to confusion over their applicability in other jurisdictions with US persons, non-US persons, brokers and traders all playing a part. Recently, the CFTC and European Commission announced an agreement allowing multilateral trading facilities (MTFs) to register as SEFs. ICAP, the large interdealer broker (IDB), has asked the CFTC to regulate its European entity. Questions remain as to whether other MTFs will follow ICAP. Additionally, by whom, when and how the SEF rules will be enforced in Europe has not yet been addressed by regulatory agencies. Whatís more, the announcement regarding SEFs in Europe made no mention of organized trading facilities (OTFs), which were originally expected to be the SEF equivalent in the European Union. Considering the technical standards for these new trading facilities have not yet been published by the European Securities and Markets Authority (ESMA) and the rules arenít expected to be in force until 2016, there will likely continue to be some uncertainty and confusion.
The Made Available to Trade (MAT) rule has forced the movement of certain formerly OTC transactions onto SEFs, designated contract markets (DCMs) and foreign boards of trade (FBOT). The rule, as created by the CFTC, will allow SEFs to choose which products they will make available on their platforms. The final rule mandates that once a SEF makes a product available to trade, a US person seeking to trade that specific product may do so only on a SEF. While the transaction must be traded on a SEF, it does not need to be traded on the first SEF to make the product available to trade; rather, the MAT products can be traded on any SEF after the effective MAT date. These MAT determinations for “required transactions” took effect on a rolling basis, starting with interest rate and credit derivatives. Several SEFs filed MAT determinations with the CFTC and the first required transactions began on February 18, 2014 (see Figure 2). Two exceptions currently exist for this rule. The first is the block trade exception, which allows transactions over a set notional value to be performed off-SEF but then reported through a SEF within 15 minutes. Additionally, the CFTC has issued relief for packaged transactions, allowing instruments to be traded in combination off-SEF regardless of their MAT status until May 15 at the earliest.
In addition to trading required transactions, the SEF can also offer access to OTC markets in permitted transactions which are OTC swaps that have not been mandated for SEF, DCM or FBOT execution and that may or may not be subject to a clearing mandate.
The CFTC has mandated that all multi-to-multi electronic platforms that specialize in certain FX product types, specifically FX options and non-deliverable forwards, must be registered as SEFs. While these transactions are not currently required transactions and the transactions themselves are not yet mandated for clearing, the CFTC requires the platforms to register and comply with the SEF rules. This has further complicated market participantsí quest for clarity in the post-SEF world and has confused the market with respect to the CFTCís next steps regarding FX, equity and commodity products which fall under its purview.
What Will the Future Hold?
How the market will look and operate in the long term will begin to be defined by what happens over the next six months. Three key trends in the coming months include OTC and exchange-traded derivative (ETD) convergence, SEF aggregation and new business models for banksóall of which could spark new opportunities.
OTC and ETD Convergence
There is a view among some market participants that demand will shift away from OTC trading on SEFs due to increasingly onerous regulatory requirements and move toward exchange-traded derivatives, specifically swap futures. Swap futures are designed to mimic standardized OTC swaps but have reduced margin requirements relative to cleared swaps. While there has been an increase in the volume of swap futures, this trend does not necessarily reflect a wholesale shift away from OTC products. In fact, results from ISDA’s recent survey of 245 market participants on the economic value of OTC derivatives imply they are becoming a more popular form of risk management: 80% of respondents expect to use them going forward.2
In this context, the differences between OTC swaps, swap futures and other exchange-traded derivatives are significant. Among the most important are the hedge accounting rules, which are commonly used by swap users to mitigate undesirable earnings volatility caused by mark-to-market valuations. This relief to the mark-to-market rules is only available if the hedging party can clearly document the ability of the hedge to mitigate an actual risk. With the standardization inherent in a swap futures contract, the risk mitigation argument is significantly more difficult to make due to a standardized contractís inability to mirror the precise risk factor. Additionally, there is significant uncertainty around the way in which the IRS will treat these futurized swaps for tax purposes. These differences, along with the uncertainty around the long-term regulatory treatment of swap futures, have proven to serve as a disincentive toward broader and faster adoption of swap futures products.
Price discovery on SEFs can occur through a request for quote (RFQ) or central limit order book (CLOB). To date, the vast majority of current SEF volume is conducted using the RFQ methodology, which is relationship based and follows an on-demand market-making principle. CLOBs, which are common in the ETD and equities world, are characterized by a continuous stream of prices on both sides of a market. CLOBs are common in products with high volumes and liquidity. At this point, it is unclear as to the role that CLOBs will play in the evolution of the SEF markets. In the listed space, quotes of small notional value are often streamed into a CLOB. As a market participant seeks to execute a transaction, he or she would submit an RFQ. As other market participants respond to the RFQ, the width of the market would tighten and the size available to trade would increase. This is a likely first step in the creation of a CLOB on a SEF.
With their unique market structure, SEFs can connect to multiple CCPs and market participants can connect to one or more SEFs either directly or through an FCM. Given that products are fungible on the CCP level, the choice of SEF is unimportant. Over time and as market participants get over their initial frantic onboarding to SEFs, best execution in terms of price will become more important, as will terms common in listed products, such as the width and depth of the market. The SEFs able to foster the creation of these “best markets” will be the long-term winners in the space.
The single largest area of convergence may well lie in the impact of electronic trading on the OTC market. While mandatory electronic trading is still in its infancy, there are some signs that those familiar with the transition to electronic trading in the listed space will recognize. New entrants and former market takers who have not previously acted as OTC market makers are beginning to change the market and bring their own version of aggressive market making, speed and risk management to bear. Market takers are increasingly requesting RFQs from the entire market and not just from those dealers with whom they have prior relationships. There has been evidence that some traditional buy-side firms have been actively “making markets” for other buy-side firmís RFQs resulting in a new ìall to allî market paradigm. Many market participants are anticipating continued rapid evolution over the course of the next twelve to eighteen months.
Identifying SEF Liquidity
Of paramount importance to swap market participants is to determine to which venues they should direct their order flow. The quest for best liquidity has been complicated due to a lack of coordination in reporting volumes among SEFs. The CFTCís lack of specificity for calculation and reporting methodologies has not helped the situation. Some issues include the double counting of volume, inconsistent timing conventions, inconsistent currency accounting conventions and inflated transaction counts due to the inclusion of product types not yet mandated for execution on SEFs. The result is a confusing and fragmented view of the market that makes it difficult for participants to determine the markets with the tightest spreads and deepest pools of liquidity in pursuit of best execution.
New Market Structure Leads to New Business Models
Despite the current confusion, the structural market changes initiated by the creation of SEFs, which are noted in Figure 3, have incentivized banks and dealers to re-evaluate their businesses and create new models, many of which are borrowed from the listed world.
Sponsored access is a model whereby an FCM provides connectivity to SEFs in such a manner that the FCMís clients do not need to onboard directly to a SEF. This requires the FCM to provide some level of assurance on SEF rulebook compliance while allowing the client to quickly onboard to the SEF. Typically, the FCM charges a commission and/or a monthly fee to clients for sponsored access.
Agency execution, as used in the futures industry, is where dealers pass through customer-generated order flow to the SEF and charge a fee rather than generating revenue on the bid/ask spread. The main question for the dealers will be how to position their services to attract profitable scale. As execution becomes more commoditized, clearing fees will likely become increasingly important. Banks and dealers could establish SEF aggregation services, routing client orders to the appropriate SEFs and charging a fee for the service. This “smart routing” is a current differentiator in the listed equities and ETD space.
SEF aggregation is very simple conceptually and can be performed by a front-end application on a traderís desktop. Since many SEFs will be able to provide identical products to one another, it stands to reason that firms would like to see which SEF has the best price on their product of choice. The term aggregation is used to imply that firms will tend to look at SEFs as one market with the same instruments, CCPs, FCMs, etc. The actual venue or SEF may be different; however, that is largely irrelevant post execution. SEF aggregation is simply part of the search for best execution. By taking some lessons from the past, the OTC world has an opportunity to transform itself by combining various connectivity options, such as sponsored and direct access, with new services such as agency execution and SEF aggregation or “smart routing.” This model would provide flexibility to all participants and will appeal to lower-volume/lower ticket-sized clients who cannot sustain the prohibitive fixed upfront costs of onboarding to each SEF.
Larger participants who want to take advantage of this opportunity are likely to enhance their businesses to attract client flow for sponsored access or agency execution, rather than get out of the market-making spread-based model altogether. Offering a holistic or aggregated view of the entire SEF market is an option for those dealers who are forced to fundamentally alter their existing business models to remain competitive in servicing their buy-side clientele. There are early indications that several dealers, in conjunction with some start-up players, are moving toward offering aggregation. Importantly, the SEFs themselves must be open to working with an aggregator and responses have varied among SEFs. The emerging aggregator connectivity model will require an addendum to the individual SEF rulebooks and industry-wide adoption is uncertain.
From the SEF trade volumes published to date, it seems likely that established interdealer brokers and firms with significant pre-SEF volumes appear poised to îwinî the first phase of mandatory SEF execution. Newly established SEFs have struggled and will be forced to specialize, differentiate and innovate with value-added offerings. Moving forward, established players must continue to evolve as this structural market change threatens their legacy business lines. There is a significant likelihood that many former dealers will increasingly depend on a more fee-based revenue model, which could include charges for execution, connectivity, clearing and collateral management services. Embracing new business models will be the key to their success in light of the new market reality. SEF aggregation can take many forms with a variety of market access models, but the intent is all the sameóhow does one achieve best execution in the new market? With the dynamics evolving, the following 18 months will be pivotal in terms of defining markets and businesses for the next decade.
- Ryan Baccus, Paul Gibson and Jon Szehofner, “Mandatory Electronic Exchange: Determining the Right Market Model for OTC Derivatives,” Wall Street & Technology, (2013), February 28, 2014, http://www.wallstreetandtech.com/data-management/mandatory-electronic-exchange-determini/240147503
- ISDA AGM to Highlight Economic Value of OTC Derivatives; Survey Finds Derivatives Are Important to Almost 90% of End-Users’ Risk Strategy, http://www2.isda.org/news/isda-publishes-research-papers-on-the-value-of-otc-derivatives
is a Senior Manager of Business Consulting based in Chicago. Since joining Sapient Global Markets, Jim has helped exchanges deal with the challenges associated with increased regulatory and competitive pressures. He has also focused on a variety of regulatory change initiatives spanning the US, Europe and APAC. Prior to joining Sapient, Jim spent 17 years managing and trading as a partner in several proprietary trading firms and is an expert in exchange-traded derivatives.
is a Business Consultant based in London specializing in capital market initiatives. He is currently working at a top European investment bank focused on the impacts of regulatory reform on execution, clearing and reporting workflows. Prior to this, Paul spent time at a top market infrastructure provider, initiating a cross asset-industry project designed to facilitate the reporting of OTC derivatives to a global trade repository.