The advent of swap execution facilities has not brought about the open access to trading that buy-side participants expected.

What’s happening?

The US swap execution facility (SEF) mandate came into force in February 2014. Any swap deemed by an SEF to be made available to trade (MAT) on its electronic platform must be traded through a SEF and cleared through a central counterparty. Central clearing is designed to reduce bilateral counterparty risk in derivative trades, while SEF trading is intended to increase price transparency and ensure equal access for all participants.

However, the Commodity Futures Trading Commission (CFTC) devoted part of the first meeting of its newly created market risk advisory committee (MRAC) in April 2015 to the question of why SEFs have not fulfilled expectations. More than 50% of swap trades now take place on SEFs, but buy-side representatives at the MRAC complained that the underlying relationships between market participants have not changed. 

What’s the problem?

SEFs offer two general methods of trading. Clients can place requests for quotes (RFQs) that will be fulfilled by dealers, or market players can participate in a central limit order book (CLOB) that operates in the same manner as a stock exchange. But SEF market activity is bifurcated, and increasingly consolidating around a few platforms. Most dealer-to-client SEF business happens on an RFQ basis on Bloomberg or Tradeweb. On the other hand, dealers are hedging client trades on a CLOB basis, on SEFs operated by the dominant inter-dealer brokers such as ICAP and Tradition. The CLOB allows the SEF to operate more like a conventional exchange.

With dealer inventories shrinking as banks seek to comply with tougher capital requirements, buy-side participants want all-to-all trading through CLOBs to maintain liquidity in the swaps market. But if clients want to participate on a CLOB, the SEF typically requires post-trade name disclosure, which results in information leakage into the market about the client’s positions.

Reg rage - exasperation

“The motivation for central limit order books is to bring counterparties together to create liquidity. From an academic perspective, it seems straightforward that anonymity enhances liquidity, and when you give up anonymity you discourage participants who want to protect their trading activity from disclosure to the rest of the market,” says Andrew Lo, the professor of finance at MIT Sloan school of management who chaired the MRAC discussion on SEFs.

What does the industry say?

Post-trade name disclosure was standard practice in the world of bilateral swaps trading, because dealers were left with counterparty risk exposure. Since all SEF-traded products are centrally cleared, this motivation should be removed. A further argument in favour of name disclosure is that it allows dealers to offer better liquidity pricing due to the extra market information. Large clients may also have specific commission arrangements with their dealers. But these arguments cut little ice with other market participants.

“If a client is looking for preferential treatment in return for delivering a dealer a certain share of their execution flow, they can trade in the disclosed RFQ format where their identity is known to the dealer pre-trade. Anonymous CLOBs are intended to provide a different option for clients for risk transfer based on the client’s preference with the additional benefit of promoting transparent price discovery. Since there is no way that dealers can provide price improvement post-trade based on the identity of the client, what is the benefit of post-trade name give-up?” asks an industry consultant who works with the CFTC on these matters.

What remains to be seen is whether this will lead to enough pressure for SEFs to change their own rule books and access conditions.

“We think there is more subtlety to the discussion than simply saying name give-up impairs liquidity. There are a lot of operational factors to people participating on CLOBs, from a credit check perspective and the willingness to trade anonymously. Given the breadth of instruments available on the interest rate swap curve, we are also not entirely convinced there is enough standardisation for a wide adoption of CLOB activity at this stage. Over time, we expect growth of CLOB trading, but the market will need to evolve from a product and an operational standpoint,” says Douglas Friedman, general counsel at Tradeweb.

Should the CFTC act?

Buy-side participants and their trade bodies think it should. Adam Jacobs, head of markets regulation at the Alternative Investment Management Association (AIMA), says the issue “probably will need regulatory intervention, because there are vested interests in keeping platforms separate”.

“Our members are keen to break down the distinction between dealer-to-dealer and dealer-to-client liquidity, and it is important to have a framework in which SEFs cannot design their rulebooks specifically to exclude certain participants. SEFs need to have minimum access criteria, but there is a question about what the appropriate criteria should be, and they should be non-discriminatory,” says Mr Jacobs.

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