The cautious approach to swap execution facility trading witnessed last week signals the buy-side’s desire to establish relevant counterparty arrangements and perform test trades, but also a willingness to hold off from total immersion until regulatory mandates kick in.
How have institutional investors reacted to the 2 October launch date?
Since the formal launch of swap execution facility (SEF) trading last Wednesday, institutional investors have dipped a speculative toe into this new world of OTC derivatives trading.
According to buy-side firms, participation with SEFs so far is overwhelmingly based on setting up connectivity and counterparty agreements with these newly formed venues. A report last week from consultancy TABB Group found 77% of 36 institutional investors surveyed did not trade swaps on a SEF on the Wednesday at all, while 14% had begun, and 9% had conducted test trades only.
This figures suggest while some early movers are keen to have all the necessary arrangements in place to trade on SEFs, most have taken a conservative approach, and will maintain bilateral swaps trading until forced to do otherwise by the Commodity Futures Trading Commission (CFTC). Most OTC derivatives will have to be traded on SEFs from November in line with Dodd-Frank Act implementation, so buy-side firms technically have no regulatory requirement to use SEFs until then.
What will SEF liquidity resemble in coming months?
Industry participants believe SEF liquidity will continue to be linked to regulatory deadlines mandating swaps trading on SEFs. That said, initial volume figures reported by SEFs since Wednesday show a growing impetus from investors to use the venues.
Reported trading volumes on Bloomberg SEF, for instance, reached 110 trades for the Wednesday, with a value of US$6 billion, a quarter of which was in interest rate swaps, according to Bloomberg figures. On Thursday this doubled to US$13 billion in total transactions.
If volumes continue to grow exponentially, this could lead to a wholesale shift of liquidity from the traditional bilateral swaps activity in leading OTC derivatives by volume, interest rate swaps and credit default swaps, which could lead the bulk of asset managers to follow the early movers onto SEFs.
Volumes are expected to pick up dramatically from November and December, when two key rules (described below) take effect. However, the venues have yet to establish themselves as key sources of liquidity in certain products and a period of consolidation across the SEF landscape is expected as trading volumes increase.
What regulatory changes will impact buy-side trading on SEFs?
The 2 October date set by the CFTC for SEFs to begin trading comes at least a month before the Commission will require all OTC derivatives trades listed under Dodd-Frank to be traded on these exchange-like venues. When the CFTC mandates SEF trading in November, asset managers will no longer be able to trade bilaterally through banks for these instruments.Also, the CFTC’s controversial ‘make available to trade’ rule is expected to come into force in December, which will likely further increase SEF activity. The rule means SEF operators themselves decide which instruments can be executed on their venue, but once trading is available in that instrument, bilateral trading in that instrument will not be allowed.