Swaps traders resist moves to increase use of platforms

By Michael Mackenzie. This article originally appeared on the Financial Times website, FT.com on September 16th, 2014

Reforming over-the-counter derivatives remains a work in progress, as investors, banks and trading venues in the US come to grips with a new era of transacting swaps.

From a regulatory perspective, the clearing and reporting of US OTC derivatives largely meets the G20 objectives established in the wake of the financial crisis. The US remains well ahead of Europe in terms of writing swap rules.

Clearing the credit of individual swap market participants addresses concerns about systemic risk that were acutely highlighted by the collapse of Lehman Brothers in 2008 and the rescue of AIG, the US insurer that had underwritten massive credit derivative trades that backfired. Allied with the regular reporting of swap trades, regulators now have a better idea of market risk.

Kevin McPartland, head of market structure research at Greenwich Associates, says: “We know a great deal more about what is trading and at what price, than before. That represents an enormous change for the swaps market.”

In contrast with clearing and reporting, trading of swaps has altered little since Swap Execution Facilities, the new transaction venues, began operating this year.

Instead of one large OTC market comprising dealers and their clients transacting across electronic platforms, the structure of trading in the US remains largely intact. Trading remains largely voice-based and split between two sectors; one where dealers trade with their clients and a separate market where dealers transact with each other in order to offset their client business.

This partly reflects the unique nature of OTC swaps and also aggressive lobbying by the industry, as rules governing the trading of swaps were fleshed out by the Commodity Futures Trading Commission in recent years.

The swaps industry resisted efforts to make derivatives trading operate as a single “all to all” electronic market on a Sef, stressing how a choice of electronic and voice methods helps maintain optimal liquidity in OTC products.

Tod Skarecky, senior vice-president at Clarus Financial Technology, says the majority of Sef trades are being done via voice and the request-for-quote protocol, rather than using an electronic order book. Under the Dodd-Frank Act, such trading protocols are allowed, but their dominant role means the OTC swap market has not become more electronic.

“While RFQ and voice are means of ‘interstate commerce’ and hence allowed, this is certainly not the electronic order book that was envisioned,” says Mr Skarecky.

In contrast with expectations that institutional investors would look at electronic trading across a range of new Sefs, the reality so far is that they prefer asking dealers for quotes over Bloomberg and Tradeweb, whose platforms dominate volume. This reflects a number of factors, namely how electronic venues tend to transact small sizes, while big investors prefer executing large notional swap trades and maintaining old relationships with their favourite dealers.

Keith Bailey, managing director at Barclays, says trading volumes on Sefs will grow, as more swap categories become subject to the trading mandate. But broadly, he says the introduction of Sefs has not attracted many new players to the swap market. Some entrants are focused on electronic execution in order books, but, as expected, essentially the same entities trade swaps as did before, and for the same reasons.

This means that a number of start-up Sefs face a tough future as they wait for investors to look at trading swaps via an electronic order book. The more likely scenario is that the number of Sefs consolidates.

“We will probably see the bigger venues only look at the new entrants that have unique technology,” says Mr McPartland.

Since Sef trading officially began this year, volume and activity data have revealed the unique nature of the OTC market in that, unlike futures, trade sizes are generally larger and sporadic among a smaller universe of participants.

Interdealer brokers, such as Icap and BGC, remain the main participants in swaps executed between dealers, based on weekly volume data from Clarus.

Under Sef rules, IDBs have to open their platforms to all types of swap users, including the traditional clients of dealers. The expansion of IDB customers has largely been limited to specialised companies, known as high-frequency traders.

As a result, electronic order book volume is picking up for standardised swaps in the interdealer market, which is also very global in nature, and waiting for derivatives reform across Europe and Asia.

Alex McDonald, chief executive officer of the Wholesale Markets Brokers Association for IDBs in Europe, says: “Our members’ focus has been on rolling out Sefs in the US, and now they are looking at making sure new platforms in regions such as Europe, help pool global swap liquidity.”

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