Buy-side uptake of CLOBs can drive SEF growth

The uptake of trading on swap execution facilities is creeping upwards, but it is the buy-side which hold the key to injecting rapid growth into the platforms, according to industry experts.

The uptake of trading on swap execution facilities (SEFs) is creeping upwards, but it is the buy-side which hold the key to injecting rapid growth into the platforms, according to industry experts.

After almost a year in existence, around 50% of interest rate swaps and 70% of credit default swaps are now taking place on the electronic trading platforms in the US.

SEFs launched in October 2013, with the mandatory trading of interest rate and credit swaps enforced in February this year. The venues were set up as a way of pushing OTC derivatives through electronic platforms in a bid to reduce systemic risk in the market.

Though volumes have been increasing since October, the buy-side has been slow to begin using SEFs, mainly due to a lack of adoption of the use of central limit order books (CLOBs) on the venues.

“The biggest surprise and the biggest disappointment is the lack of pickup in the CLOBs for the most liquid swaps,” said Michael O’Brien, director of global trading, Eaton Vance, at the International Swaps and Derivatives Association’s (ISDA) European Conference in London.

“The transparency of the order book, even when you are doing an RFQ [request for quote], is a huge benefit. If the demand is there from the buy-side then all the other pieces will fall into place.”

SEFs match orders through both request for quotes (RFQs) and CLOBs, with the latter being more transparent due to a centralised liquidity pool.

The RFQ model is more based on relationships and is allowing the buy-side to receive a better price at present.

This limited uptake from the buy-side on the order books has applied the brakes to SEFs in their bid to gain traction.

“We have a great opportunity to increase transparency and break down the traditional dual-market structure in the most liquid tabs and yet it hasn’t happened,” added O’Brien. “A large part of that is the buy-side not participating in the order books.”

The general consensus of the panel was that this would change over time, it is a matter of breaking trends and steering the buy-side towards the new OTC model. Getting the buy side to fill the books with bids and offers will be a slow process though.

Nathan Jenner, chief operating officer, fixed income currency and commodity E-trading, Bloomberg, said that the tide may be beginning to turn on its SEF.

“For the first 10 months, very few of the orders were on order book. Something we have done in the last week or two is that we have put our order book pricing next to our ALLQ pricing, which is where a large portion of the buy-side trades credit default swaps today, even just by doing something very simple like that we have seen a rapid growth in terms of buy-side participation.”

ISDA data has showed however that volumes are steadily rising on the electronic platforms. Overall, activity has risen 137% since October, mainly due to the made available to trade (MAT) mandates in February.

Since then, the increase has been slower, up only 5% from February to August. Trading on SEFs though looks to become the dominant way of trading OTC interest rate and credit default derivatives in the US. 

Peter Best, chief operating officer, ICAP SEF and ICAP Global Derivatives Limited, said along with buy-side participation, a volatility boost could also ignite the SEF space.

“Without a doubt what will drive liquidity in the near future is the return of volatility which will get markets moving again,” he said.

Best added that volumes would also lift as more MAT determinations come into force, but warned regulators against rushing the implementation.

“Nothing would be traded on a SEF if there wasn’t a requirement to do so,” Best added. “I hope the MAT determinations are later rather than sooner, when we talk about the products that are next in scope like NDFs, there are a lot of cross-border challenges which need to be solved before trading on a SEF.”

The combination of market volatility and buy-side adoption of CLOBs could spark a surge in activity on SEFs in the near future, but until then the platforms face the same slow uptake which they have experienced since the initial MAT determinations in February.