Pre-trade uncertainty “disastrous” for electronic swap trading

New US pre-trade rules are pushing market participants back to voice trading of swaps, despite regulators’ aims to increase electronic trading on swap execution facilities.

New US pre-trade rules are pushing market participants back to voice trading of swaps, despite regulators’ aims to increase electronic trading on swap execution facilities (SEFs) .

Speaking at a conference for asset managers in London this week, Andrew Ross, European head of OTC central clearing at Morgan Stanley, said rules introduced by the Commodity Futures Trading Commission (CFTC) under the Dodd-Frank Act had led to a significant decline in electronic trading of swaps.

Prior to the official go-live date for SEFs on 2 October, many swaps were already trading electronically but the change in rules is causing traders to avoid electronic trading of OTC derivatives.

“The launch of SEFs has been disastrous for electronic swap platforms and many traders are now reverting to voice trading,” said Ross.

According to Ross, the main problem is a lack of pre-trade certainty. When trading swaps on a SEF, counterparties need to be sure that a trade can clear before it is executed and this means rapid credit checking of counterparties is required.

While many technology providers have stepped in to provide solutions to enable rapid credit checking, most market participants are wary of having to serve as guinea pigs.

Ross explained: “Most of this technology is very new and untested so a lot of traders are simple avoiding using it, preferring to use voice trading until they can be sure the infrastructure works.”

Although no figures separating swap trades on electronic platforms and voice trading have been published, a recent survey of buy-side firms by consultancy Tabb Group found 77% did not use a SEF on the first day of trading and were moving their swap trading to London to avoid SEFs.

The switch back to voice trading goes against the CFTC’s aims to make as many swaps as possible electronically traded and centrally cleared – in line with the G20 mandate set out in 2009 – hoping this will improve investor protection in the swap market.

While the current rules mean traders can switch to voice trading, the upcoming introduction of the ‘made available to trade’ (MAT) rule will mandate electronic swap trading in certain instruments once a SEF operator has made them available on its platform.

MAT concerns

Several MAT applications have already been made and the first mandated swap trading on SEFs is expected to occur before the end of the year, but market participants are still worried about the impact of the MAT rules.

Douglas Harris, managing director at advisory firm Promontory Financial Group, told a Securities Industry and Financial Markets Association meeting on Tuesday the impact of MAT applications could significantly alter how participants engage with SEFs and possibly increase systemic risk.

So far, four SEFs have submitted MAT applications – trueEx, MarketAxess, Tradeweb and Javelin. The latter has proposed to facilitate execution of the broadest range of instruments, a move that increased concerns about the MAT rule, as less liquid instruments could lead to a higher risk of default within clearing houses.

“Just because an instrument is clearable, it doesn’t mean there is enough liquidity,” Harris said.

He added that firms had struggled to decide which SEFs to connect to, as some platforms had migrated volumes from other systems, while others were completely new.