The strongest contenders in the nascent swap execution facility (SEF) market will offer trading across multiple asset classes or deep liquidity in established niches, according to capital markets consultancy GreySpark Partners.
A new report by the firm, ‘SEFs – The business landscape’, assesses the functionality of more than 50 platforms that are expected to compete for transaction volumes as US OTC derivatives migrate from bilateral dealing to centrally cleared trading platforms. Under the Dodd-Frank Act, the Securities and Exchange Commission regulates trading in security-based instruments such as single-name credit default swaps, while the Commodities Futures Trading Commission oversees index-based credit defaults swaps, interest rate swaps and other non-security-based derivatives, such as FX and commodities.
SEF operators expected to thrive by GreySpark include asset class-specific platforms such as FXall and MarketAxess as well as broader offerings from Tullet Prebon and Bloomberg.
GreySpark’s analysis suggested that the most successful SEFs would look to expand into the three most liquid areas of OTC derivatives: credit default swaps, interest swaps and FX options, potentially leaving other markets less well-served. Some SEFs are planning to specialise either in the dealer-to-dealer (D2D) or dealer-to-client (D2C) market while a few will attempt to serve both markets. According to GreySpark, SEFs gravitating toward D2C will offer request-for-quote or click-to-trade markets while D2D platforms will operate a central limit order book. Some platforms will offer auction capabilities of varying lengths, while others are expected to only support limit and not market orders. Another area of differentiation is post-trade connectivity. GreySpark said that some SEFs would connect to clearing houses based on client demand while others would offer post-trade choice more proactively perhaps in conjunction with a third-party connectivity provider such as Marketwire. Bradley Wood, a partner at GreySpark, said SEFs were looking into whether clearing houses would be able to provide real-time margin information at the pre-trade level.
While SEF providers may be due for a windfall, Richard Perrott, analyst at private German bank Berenberg, said market reform was generally a negative for large brokers, where OTC derivatives dealing account for almost 25% of revenues. He said costly increases in trading transparency, penalisations for non-standardised derivatives and greater central clearing will put revenue pressure on banks.
“Basis point charges for OTC derivatives – typically 10-times higher than listed equivalents – will likely decline though remain significantly above exchange-traded counterparts, reflecting OTC’s inherent lower liquidity and greater complexity,” said Perrott. “Dealer top-line pressure will be compounded by operating headwinds as banks invest in new trading and post-trade systems, the cost of which may not be fully passed on to clients.”
Perrott recently put a buy notification on a global inter-dealer broker Tullett Prebon, one of few brokers he sees with a present cheap valuation, strong balance sheet and scope for increased capital return from the pending launch of its own SEF.
Both US regulators are still finalising their rules for the new OTC derivatives trading environment, with SEFs expected to start trading in January 2013.