Dealers are investing in liquidity aggregation systems to pool liquidity for buy-side clients as the arrival of swaps execution facilities (SEFs), the new breed of exchange created under the US Dodd-Frank Act to trade OTC derivatives, draws closer to reality, according to a new report by financial research firm TABB Group.
Endorsed by the G-20 countries, Dodd-Frank aims to move as large a proportion of OTC derivatives trading activity as possible onto SEFs. In early December 2011, the US Congress’s House Financial Services Committee determined that SEFs should serve as a platform for executing swaps and security-based swaps by requiring immediate execution of matched trades and allowing market participants to receive and respond to a single quote.
However, many dealers believe that the new rules effectively mean that liquidity in the most liquid parts of the swaps market will fragment. TABB reports that swaps dealers intend to spend US$504 million to create the new aggregation systems they consider necessary to counter the fragmentation of liquidity. Interest rate swaps and index credit default swaps are tipped to see the widest adoption of the resulting aggregation solutions.
“Swaps liquidity is going to fragment,” said Kevin McPartland, a TABB principal, director of fixed income research and author of Swaps Liquidity Aggregation: Best Execution to Product Selection. “Whether there will be three or as many as 10 SEFs per asset class remains unclear, but finding the size you need at the right price will become less about who you know and more about the quality of your aggregation technology.”
Most swaps dealers and some technology providers are already building aggregation systems, according to TABB. However, the report also warns that aggregating request for quote and order book markets into a single view will be difficult, especially given regulatory uncertainty.
Originally due in July 2011, the rules for SEFs have been delayed, following an announcement by the Commodity Futures Trading Commission chairman Gary Gensler in September that the final rules for SEFs would not be implemented until 2012. The regulation had also previously come under attack from Craig Donohue, head of Chicago-based derivatives exchange CME Group, on the basis that it does not take sufficient account of the costs and benefits of the proposed new rules.
Previous research has shown that although US regulators expect to begin the implementing SEF trading mandates by the third quarter of 2012, over 80% of market participants do not expect implementation until 2013.
“Even if the final rules are passed early in 2012, industry lobbying and a change in the White House in 2013 could see the rules shift yet again,” said McPartland. “But the swaps market will fragment. The need for SEF aggregation is serious and it’s not going away.”