A report suggesting how buyside and sellside firms in the swaps space should adapt their business models to cope with the fragmentation of liquidity resulting from the proliferation of swap execution facilities (SEFs) has been released.
The report, titled SEF Aggregation: Approaches, Pitfalls and Solutions, is the third of three from research firm GreySpark, which looks at the changes that are expected in the swap execution landscape. The first looked at the business landscape and who are the likely SEF providers to emerge and the second looks at how firms will connect to SEFs.
SEFs are one of the primary mandates of the Dodd-Frank Act. They are required to increase pre-trade price transparency, post-trade trade transparency and minimize bilateral exposures between swaps counterparties. Under MiFID in Europe, multilateral trading facilities (MTFs) and organized trading facilities (OTFs) are expected to converge with SEFs from a regulatory standpoint. MTFs and OTFs are the EU equivalent to SEFs.
The key focus of the third report is aggregation, namely bringing together liquidity together in aggregated form to serve a business. While the regulation is in flux and some softening of the rules is expected, the report looks at a variety of asset classes that will be affected. The third report focuses on liquidity aggregation and execution management. It addresses a number of concerns which are particular to this market, including the question of how the quality of liquidity should be managed when tackling an aggregation and/or order routing project.
GreySpark partner Bradley Wood notes that the main change will be in the pre-trade space. Going forward the buyside will be able to put pressure on dealers via an RFQ based platform, with a fully executable price, enabling clients to have a last look, he says.
The advent of SEF trading will cause liquidity fragmentation across a number of venues, as over 50 institutions are considering proposing a SEF or OTF solution across one or more asset classes.
As a result of the fragmentation of liquidity that will come via various routes to market via the execution facilities, giving clients a wider choice competitive pricing and more transparency, the sellside and buyside business models are expected to change, says GreySpark. This will be highly relevant for FX, rates and credit. Current FX business models for cash products are based on liquidity aggregation with derivatives requiring the same practice, says the report.
For rates and credit, there will be a real aggregation particularly for instruments traded electronically. Relevance of aggregation is high for buyside and sellside participants seeking to be at the forefront of market changes as the number of swaps for these products is expected to be high.
With regulations pushing post-trade transparency (via standardization and reporting to central repository) and counterparty risk (via CCP and clearing) look to be relatively achievable objectives, pre-trade transparency, via electronic trading and public price dissemination, equal access to firm liquidity will be the norm.
Altogether clearing and reporting of standard swaps is widely accepted by the market. The remaining issue is the technical definition of how unique participants, instrument and trade identifiers are going to be defined and shared, notes the report.
The trend in the regulatory process is to soften the requirements on the trading models, in particular regarding price publicity and access to competitive trading on quote-driven D2C markets.
Currently the business models of banks are based on the segregation between client distribution (D2C) and inter-dealer negotiation (D2D). Banks provide their clients with swaps by advertising their offering and trading through their SDP or through the MDPs. They access swap liquidity through IDBs, either for their own hedging needs or to source liquidity for client trades. Looking at likely business models if the fixed income and commodity derivatives markets take paths similar to equity-based securities and derivatives markets, D2C MDPs will retain their core essence and the SDPs will still be allowed to execute against clients if they are also able to route orders to the market and prove best execution, says GreySparks report. D2C operators will be trying to predict and protect their existing franchises. They need to provide electronic execution as opposed to voice-based execution, it says. They must have a best execution obligation and it will be less relationship based. Smaller margins and higher volumes will be the big threat in this area giving D2C the greatest challenge.
For clearing brokers there is an opportunity because clearing is a lucrative business to be in. The money on execution is likely to decrease and the money will be on clearing, notes Wood. They are in a position to attract most volume on the trading area to leverage economies of scale and take the costs out. There is a high emphasis on counterparty risk and exposure and that is challenging the priority of clearing.
Most traders on the sellside currently use standalone broker screens, on which they manually place quotes and orders. Asset managers would be willing to have the activity on quote based systems and can use the service of an execution broker.
Clients such as asset managers, insurance companies, corporate clients and hedge funds do not have access to order book venues. They are accessing liquidity from dealers on the basis of prices advertised privately to them through SDPs or MDPs.
In the new framework, hedge funds can qualify as aggregators and can enjoy access to liquidity under the new regulations.
D2Cs and D2Bs will be looking to build an aggregation function on the buyside. For the interdealer brokers there will be no threats as long as they register as an SEF or an OTF, says the report There is more direct market access and an ability to connect with minimal intervention.
The single dealer must evolve to meet pre-trade transparency obligations and must have access to more than one liquidity source, says Wood. “If they offer an equal structure at a price that offers greater liquidity the better they will fair under the new regulations,” he adds.
Certain exchange clearers (e.g. CME) will serve as a clearer, a venue and a futures exchange. They would look like a market aggregator for swap futures, while for underlying swaps price discovery aggregation function could be the design of what takes shape in line with the futurization of these products: IRS futures have shorter timeframes, swaps have long term futures and settle for cash in three months. There is no detail on how these instruments are likely to be defined. However, it is likely that the buyside would want broker clearer/ execution venues with stock exchange competition, says Wood.
Swaps dealers, via ISDA, are lobbying to ensure there is no change to their trading models. Hedge funds want to connect to D2D SEF in an order book model while D2Cs will monitor the flows and offer best execution to their client.”Hedge funds will consider investing in their own aggregation solutions so as to exploit the arbitrage opportunities that will result from liquidity fragmentation,” Wood adds.
The SEF process will roll out in the next six months and by the end of next year many of the SEFs will be built.With this clients will have the best range of possible prices. The SEFs will have made a good effort to expose the D2Cs or IDBs client to the best possible price,” says Wood.
-Janet Du Chenne