IDBs to re-aggregate OTC derivatives liquidity in the US

Experts will tell the Commodity Futures Trading Commission tomorrow that interdealer brokers are best placed to handle the aggregation of swaps liquidity following the arrival of new OTC derivatives rules.

Experts will tell the Commodity Futures Trading Commission (CFTC) tomorrow that interdealer brokers (IDBs) are best placed to handle the aggregation of swaps liquidity following the arrival of new OTC derivatives rules.

The CFTC’s technology advisory committee will hold two panels to discuss the aggregation of liquidity across designated contract markets (DCMs) and swap execution facilities (SEFs), and automated and high-frequency trading of swaps.

Under the Dodd-Frank Act, OTC derivatives contracts will be standardised where possible so that they can be traded on SEFs and made eligible for central clearing.

Trades that cannot be standardised will remain bilateral, but will be subject to higher capital charges. The CFTC has oversight of index-based swaps under Dodd-Frank, while the Securities and Exchange Commission (SEC) is responsible for regulating the security-based swap market.

Currently, exchanges typically have a monopoly on the futures contracts they trade.

But competition between SEFs and DCMs for listing and trading of swaps that have hitherto been traded over-the-counter is likely to be fierce.

Gary DeWaal, Newedge“We are now moving into a world where multiple platforms will trade the same product,” Gary DeWaal, general counsel at futures broker Newedge USA and one of the panellists at tomorrow’s CFTC meeting, told “There will an opportunity for firms to offer aggregation services, similar to the routing software used in the securities market that helps market participants seek best execution.”

The need to re-aggregate liquidity is likely to be of most concern to smaller market participants that do not have the capabilities to connect to all SEFs and for those that trade less-liquid derivatives contracts.

Living in the past

Another panellist at tomorrow’s meeting, Chris Ferreri, managing director, hybrid trading, ICAP – which plans to register as a SEF – believes that interdealer brokers are best placed to aggregate swaps liquidity, given their historical role as the sell-side’s counterparties in this market.

“The SEF model is based on the traditional interdealer broking model that has aggregated liquidity for the sell-side for decades,” said Ferreri. “Those IDBs that register as SEFs can continue offering this service under the improved transparency that Dodd-Frank mandates.”

Ferreri noted that one issue among firms that intend to register as SEFs is ensuring that the rules related to the mode of execution are flexible enough to reflect the liquidity of an asset at the time.

“There are some days when electronic trading flourishes and there are other days when it doesn't,” he said. “We are in a zero interest rate environment and the liquidity of some instruments is subject to change. The rules need to reflect this dynamic environment.”

DeWaal added that the continued lack of clarity on the rules governing SEFs, which are still being discussed by the CFTC and the SEC, raised some concerns.

“Some trading venues may have an interest in ensuring their products aren’t cross-listed, an issue that I don't think is really contemplated by Dodd-Frank,” he said.

Competition benefits

While the ability to manage fragmentation of liquidity across multiple platforms will lead to extra costs for buy-side firms, the advent of competing platforms is expected to lead to net benefits for the market as a whole.

“There will be a fine line between the DCMs and SEFs that want to protect the turf and limit where products trade and the buy-side’s desire for competing platforms,” said DeWaal. “There is little doubt that margins on swaps will get thinner as transparency increases, which is why there appears to be a reluctance to accelerate transparency. Spreads will diminish, but volumes will increase.”

In addition to DeWaal and Ferreri, members of the CFTC’s technology committee include Lee Olesky, CEO of Tradeweb, Bryan Durkin, COO, CME Group, Julian Harding, chairman of the Wholesale Market Brokers’ Association Americas, Supurna Vedbrat, co-head of electronic trading and market structure at Blackrock and Robert Garrison, CIO, Depository Trust and Clearing Corporation.