SEFs prepare for battle despite regulatory uncertainty

Even with the continued lack of clarity on new rules set to govern US swaps trading venues, prospective market operators are keenly preparing their offerings in anticipation of Q2 launches.

Even with the continued lack of clarity on new rules set to govern US swaps trading venues, prospective market operators are keenly preparing their offerings in anticipation of Q2 launches.

Under Title VII of the Dodd-Frank Act, OTC derivatives are required to be standardised where possible so they can be traded on newly-created trading platforms known as swap execution facilities (SEFs). Dodd-Frank also requires the central clearing of swaps, where possible, and the reporting of trades to swap data repositories.

The reporting of interest rate products and credit derivatives commenced last October and clearing of these instruments for certain categories of market participants will begin on 11 March. Yet firms planning to become SEFs are still waiting for the completion of SEF rules, expected before the end of Q1.

Nonetheless, some operators have attempted to forge ahead, including Bloomberg, which has already launched its ALLQ Derivatives platform with the intention of converting it into a SEF.

“There are some aspects we can plan for in terms of preparing our trading technology, rulebook and on-boarding process,” George Harrington, global head of fixed income trading at Bloomberg, told “Our aim is to offer a multi-asset classSEF covering credit derivatives, interest rate swaps (IRSs), FX and commodities.”

ALLQ Derivatives lets buy-side investors review indicative prices and execute directly against the liquidity offered by broker-dealers. It currently offers IRSs and credit default swaps. Other firms likely to launch SEFs or convert existing platforms include FXall, MarketAxess Tullett Prebon, State Street and TeraExchange.

“There is a lot that can be done that is not reliant on regulation,” concurred Bradley Wood, partner at consultancy Greyspark Partners. “The larger, incumbent derivatives venue operators are already taking steps to connect to central counterparties and support reference data protocols like legal entity identifiers, while newer entrants are focused on developing value-added services in a bid to gain market share.”

Among the issues on which venue operators are still awaiting clarity include the definition of a ‘block’ size trade, which will determine the timeliness of reporting obligations and the minimum number of quotes that need to be sourced under a request for quote (RFQ) matching system.

Derivatives regulator, the Commodity Futures Trading Commission, has proposed market participants using RFQ platforms should seek quotes from at least five liquidity providers, encouraging competition between dealers, while the Securities and Exchange Commission has not imposed such a limit.

Once the first tranche of SEFs goes live, competition is expected to be fierce, especially in the more liquid, vanilla swaps.

“Execution for credit and rates derivatives is already quite competitive in both the client-to-dealer and dealer-to-dealer space,” said Harrington. “New entrants will emerge, but it is already quite a tight space.”

The expected fragmentation of liquidity – which will inevitably result from multiple SEFs offering trading in IRSs and credit default swaps – may pose added costs for broker-dealers needing connectivity to multiple venues. But this is not expected to pose a huge challenge, said Wood.

“Equities in Europe had the same challenge with MiFID and the subsequent creation of multilateral trading facilities. At the time it may have been considered an unpalatable cost. But multiple venues encouraged competition, broke national exchange monopolies and presented new arbitrage opportunities. While there are significant differences in aggregating swap liquidity, they are not insurmountable.”

Nor does Wood believe futurised swaps – essentially exchange-traded futures which mimic the exposure offered by a swap – will cause a substantial diversion of the potential liquidity available on SEFs. CME Group and IntercontinentalExchange are among the exchanges offering futurised swaps for interest rate and energy products respectively.

“I am not convinced there will be a massive shift because there are fundamental differences between swaps and swap futures that make each type of instrument appeal to different market participants,” said Wood.