FIRST MOVER ADVANTAGE.
The rules may still be unclear but Heather McKenzie shows how market participants are carving their stakes.
The non-standard, bilaterally cleared world of OTC derivatives is being dragged into a standardised, electronically traded environment by a series of regulatory initiatives around the world. With detail still to be thrashed out, market participants are jockeying for position in the new derivatives landscape.
In the US, Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 creates swap execution facilities (SEFs), trading systems that enable eligible contract participants to trade on a multilateral basis. In Europe, the review of MiFID has created an equivalent entity – the organised trading facility (OTF) while similar reforms are under way in Singapore, Hong Kong and Tokyo.
In general, the initiatives cover trading, clearing and reporting of swaps transactions. The reporting element is designed to enable regulators to monitor risks that could be building up in the OTC derivatives market as well as to check whether any nefarious practices are taking place. On the clearing front, the general trend is to move away from bilateral processes and towards clearing via central counterparties.
The trading element, which is creating SEFs and OTFs, is where some players are getting excited. Matt Woodhams, head of electronic commerce at wholesale market brokerage GFI, says despite the lack of clarity regarding the rules for SEFs, there is likely to be a “mad rush” before the end of this year of organisations registering to become SEFs. “The industry is not sitting on its hands. People are assuming that swaps trading will be more electronic and they are investing in electronic platforms and connectivity.”
This is a point on which James Rucker, credit and risk officer at MarketAxess, operator of an electronic bond and CDS platform, agrees. “It is not easy to formulate a response, because the rules are not final but firms cannot afford to wait until the rules are in place. There is too much to do and if you wait, there will be only a short time to act.”
MarketAxess has begun by putting trading protocols in place, upgrading and improving existing protocols for its credit trading platform. These moves, says Rucker, will ensure that the firm can be a competitive SEF from the outset. “We want to be market-driven and follow our clients with these changes,” he says. “We are also building in functions around CDS clearing, enabling clients to choose their clearing house, for example.”
On the connectivity front, the company is building links to ICE and CME and will connect to “any clearing house that clears CDS”, he says. Links are also being established to swaps data repositories and futures commission merchants.
The final piece of the puzzle for MarketAxess is compliance and surveillance. “The National Futures Association will provide a number of surveillance services, but firms need to be connected into those and also there are some things that will have to be done internally,” says Rucker.
GFI is taking a similar approach, says Woodhams. The firm is comfortable with some of the requirements it believes will come into play and views the technology that will be required as an evolution of where the company was headed.
The right connections
Connectivity will be a significant task, says Jonathan Morton, vice president at IPC. SEFs will want to connect to as many dealers as possible and there will be a substantial increase in bandwidth and investment to facilitate connectivity between SEFs and dealers, buyside firms and data repositories. “There is a fever pitch of activity as firms bring the required capabilities online because they see a large opportunity and a rapid return on investment in the swaps market.”
Woodhams points up the importance of liquidity, “You can have sophisticated trading protocols and high-performance technology, but an SEF or OTF must have liquidity. No one will look at a system alone; it will all be about liquidity.”
Incumbents in the swaps world will look for ways to move into the electronic trading world while retaining their liquidity, he says. The task will be more difficult for newcomers who will find attracting liquidity a challenge. “Being a first mover in SEFs will be an advantage – if you have liquidity. Being a first mover without liquidity won’t be an advantage and firms may well burn cash.” Woodhams says some firms already have fallen by the wayside because they have launched SEFs too early. “Many people felt SEFs would be well established by 2012; but we are perhaps still one year away from this.”
Tim Dodd, head of product management for the SunGard Front Arena trading system, says first movers will gain a substantial advantage in attracting liquidity. He suggests a “good handful” of the large number of firms that have applied to become SEFs will survive in the long term.
“Swaps are a smaller turnover, bigger ticket area than other parts of the derivatives markets. By making trading electronic there will be some growth, but not a huge amount,” he says.
SEFs will have to support not only an order book style of engagement with liquidity, but will also have to support request for quote (RFQ) type processes. “The market structure will be slightly different so simple exchange-based platforms and ETD platforms that can cope with RFQs will have to be adjusted in order to connect to SEFs.”
Dodd says Europe is likely to develop in the same way as the US, with OTFs looking similar to SEFs in terms of capabilities. “It should be remembered that if you want to deal with US clients or markets that are going electronic, you will need to have the capabilities of participating in electronic markets.”
At present electronic trading in swaps does not mean a push towards zero latency. “It will be good to have the ability to re-quote rapidly and offer safety, but at this stage low latency won’t be pursued as aggressively as in the equities markets,” says Dodd.
Woodhams says reducing latency via methods such as co-location would be “a bit over the top at this stage”. He identifies two dimensions to bandwidth – where price updates can be made many times per second, and where updates have to ripple out across many other prices. “The OTC markets are highly correlated, so latency will be important here.”
Tanuja Randery, chief executive of market data and trading infrastructure services company MarketPrizm, says the company expects the swaps market to follow other asset classes in becoming electronic, starting with connectivity and networks and eventually opening up opportunities for vendors to provide upstream services that market participants would not consider developing or operating in-house.
“We can see a drive to have multi-asset trading systems enabling participants to consider their overall position at every point – clearly having the proper systems and technology to enable this becomes important as more assets are traded electronically. We have also seen firms sharing the know-how among asset classes and trying to capitalise quickly on new opportunities that arise.”
Financial consultancy and research firm Celent believes the future of SEFs and OTFs will be very choppy – a rollout of the platforms over two to three years, with wide block trading limits will require the industry to get comfortable with the idea of SEFs and OTFs “fairly quickly”. In its November 2011 report, Swap Execution Facilities and Organised Trading Facilities, a New Market Structure Emerges, the firm warns that regulatory momentum could fade and whatever market architecture is least disruptive but in the spirit of Dodd-Frank and the European Market Infrastructure Regulation could be adopted by end of 2013.
Celent identifies three key factors that have to be considered; price discovery, trade lifecycle and profitability. Unless these are balanced, the market structure could evolve into a scenario where “nobody wins, as liquidity goes elsewhere, dealer profitability and engagement dry up, and the high cost to trade spurs users to seek risk transfer in other financial products and markets”.
Overall, while Celent believes that SEFs/OTFs will make the swaps market more electronic, transparent and competitive, it says not all transparency is equal. “We especially believe price discovery could be hindered unless careful consideration is made to ensure the rules are adaptable and reflect the reality that the swaps market has far less liquidity than some people imagine.”