U.S. Swaps: Some Barriers Removed, Many Hurdles Remain

Since the U.S. Commodity Futures Trading Commission (CFTC) started issuing the final compliance dates for Title VII of the Dodd-Frank Act, many in the industry have waited to see trading volumes on swap execution facilities (SEFs) to take off, only to be met with a number of false starts.
By Rob Daly(2147487629)
Since the U.S. Commodity Futures Trading Commission (CFTC) started issuing the final compliance dates for Title VII of the Dodd-Frank Act, many in the industry have waited to see trading volumes on swap execution facilities (SEFs) to take off, only to be met with a number of false starts.

The trading volumes on these new venues did not dramatically increase after many went live on October 2, 2013. Neither did it happen when regulators designated the first set of interest rate swaps (IRS) as made available to trade (MAT) beginning on February 15, 2014. Even the phased withdrawal of package-trade relief, which began in May, did not make SEF trading volumes jump significantly. “A package trade over U.S. treasuries is a pretty common trade,” says Kevin McPartland, principal, market structure and technology at industry analyst firm Greenwich Associates. “That should have captured more trading on SEFs.”

Others like James Toffey, head of electronic markets at SEF-operator and inter-dealer broker GFI Group, estimated SEF-trading volumes more conservatively since their introduction. “We didn’t think there would be a dramatic market shift initially after the launch [of our SEF],” he says. Another industry source points to macro-economic developments. “If you look at the VIX Index for interest rates over the last 12 months, it has been decreasing much in the way it has for equities,” he says. “With diminished volatility comes diminished trading activity in equities and other products as well.”

No overnight success

No matter what the market volatility is or which swaps are mandated to trade, Michael O’Brien, director of global trading at asset manger Eaton Vance, sees SEF trading volume growing, but it will be a long process that will not happen overnight. He cautions, however, that SEFs will never capture the whole swaps market. “Some of the non-SEF trading volume will go to SEFs, but some of it will move to alternatives like swap futures, eurodollars and treasuries,” says O’Brien.

More institutional investor participation in SEF-based trading would be a welcome boost to trading volumes, but the buy-side is split on whether now is the time to incorporate in SEF-based trading into its investing strategies. “A good handful of large-enough buy-side firms say that they took it slow on day one but now trading on SEFs is business as usual for them,” says McPartland. “Then you have people who are not comfortable with the current market infrastructure, rule sets and clarity, so they’re holding back.”

O’Brien, whose company has decided not to trade on SEFs directly for the time being, attributes current trading volumes to a wise implementation strategy for mandated SEF-based trading by regulators. Rather than making all IRS products available to trade on the first day of mandated trading, the CFTC decided to start trading only with a set of contracts with a specific tenor. All the other IRS instruments still can be traded using established OTC methods. As time goes and the swaps market grows, the CFTC will designate more liquid swaps as MAT.

For McPartland, the SEF landscape is incomplete, and as such, it is too early to judge the success the transition of swaps trading to electronic platforms. “My gut feeling is that we are in a relatively good place, but there is some streamlining that needs to be done.”

Much of that likely will occur later this year and into 2015, says GFI Group’s Toffey. “We expect to see changes as market participants try different SEFs that they were not exposed to in the past.”

Toffey estimates that the number of SEFs will shrink, as not all platforms will be able to maintain enough liquidity to remain viable venues. “Even after attrition, there is likely to be consolidation amongst the SEFs as well.”

Pushing string

The simplest way to raise liquidity would be having the buy-side execute more SEF-based transactions, but enticing and cajoling institutional investors is proving anything but easy. There are few tools available to regulators, brokers, SEF operators and clearing counterparties to convince the buy-side to trade on or off a SEF. At the end of the day, buy-side firms need to be comfortable with the new trading environment, but many are put off by the new environment’s complexity.

“For the SEF markets to reach close to pre-SEF trading volumes, they need to simplify,” advises Eaton Vance’s O’Brien. Among his concerns is the compliance risk that signing a SEF rule-book might introduce. If Eaton Vance signs a SEF rulebook, O’Brien asks, how would it meet the requirements of the CFTC’s Rule 1.35, which demands firms to keep full, complete and systemic records relating to its business dealing in commodity interests and related cash or forward transactions? There needs to be more guidance and consensus regarding the rule’s interpretation, O’Brien concludes.

Other buy-side firms are holding off SEF-based trading until the U.S. and EU can harmonize their cross-border rules and resolve the extraterritoriality issues currently affecting the global market, according to Greenwich Associates’ McPartland, who estimates it will be two to three years before the European market will have somewhat equivalent trading and clearing rules. “The big firms, which can trade using offshore entities, will continue to do so until they feel the SEF space is robust enough in terms of workflow and handling complex orders, such as bunch orders,” he explains.

Not only do buy-side firms find regulatory requirements challenging, connecting to any of the 24 CFTC-registered SEFs can be an expensive and time-consuming proposition. “Since we don’t know which SEFs will exist in a year or two, you have to be careful where you invest that time and money for SEF connectivity,” says O’Brien. “If you selected incorrectly, you lose access to liquidity as well as wasting resources.”

Unimpressed, uncomfortable

These connections are not like the ones in the listed equities and futures markets, explains O’Brien. The selection of the right futures commission merchant (FCM), SEF and clearinghouse for a trade involves a great number of connectivity permutations and complexity, he adds. These concerns did not stop Eaton Vance from executing one SEF-based trade in February. However, the several hours it took the firm’s middle office to process that trade left O’Brien unimpressed.

His original plan was to connect to a handful of SEFs and select an introducing broker to shore up the firm’s liquidity options. “We are connected to some SEFs in terms of connecting pipes and testing them. We are ready to go, except for signing the rulebooks,” he says. “We made the decision not to sign any of them because we are not comfortable with the rule books and what they mean as well as concerns over CFTC Rule 1.35.”

Instead of joining the planned handful of SEFs, Eaton Vance decided to adopt the introducing-broker model, with which the company is familiar from the listed equities and futures markets. By connecting to the firm’s introducing broker, in this case UBS, Eaton Vance traders can have an aggregated view of the liquidity pools to which the broker is connected and send out their requests-for-quotes without needing to connect to the SEFs, clearinghouses and credit-checking utilities.

It also does not expose the firm to new and expensive regulatory requirements, O’Brien adds. “I’m surprised that there aren’t more dealers offering this model, but I expect most of the buy-side will adopt it two or three years down the road.”

«