As over-the-counter derivatives shift into electronic trading, regulators must be able to navigate a transforming marketplace. In the U.S., regulators have found answers to questions about electronic trading of OTC derivatives contracts on swap execution facilities, enabling this market to settle down to a new paradigm with certainty taking hold in many areas. Now the focus is on implementation.
The final “made available to trade” (MAT) landmark ruling voted in on May 16, 2013 by the CFTC has fundamentally changed the swaps market by effectively transferring, allocating and deferring significant power to SEFs to unilaterally bind the swaps market to mandatory participation.
The SEF mandate will drive a change from a bilateral trading, market making or position carrying dealer business to a bifurcated model driven by a SEF market making business and an agency trading business. It will also create a reduction in execution time from minutes to seconds, and even milliseconds or microseconds to nanoseconds.
The electronic trading of swaps in the U.S. requires connectivity and screens for trading and liquidity aggregation. Market participants will increasingly rely on technologies that provide smart order routing (SOR), algorithmic trading, market making and order management, direct market access (DMA) and internalization in order to trade swaps electronically. These changes also will drive a need for systems similar to the current equity and options markets for both the buy and the sell side, as well as for pricing and risk management systems.
Banks participating in this market will need to connect to electronic liquidity pools and then trade electronically; however, they are being driven to move from a principal to agency model for much of their business. No longer will customers trade directly with a bank, but rather, they will trade via a SEF where the business will be exposed to other parties to supposedly increase price competition.
Leading sell-side firms have already set up broking business models and customer flows on SEFs and are offering their own liquidity by having market makers connect directly to the same SEFs. Similarly, in the EU, large multinational banks and OTF providers are making their liquidity more accessible, and with the EMIR and the Markets in Financial Instruments Directive (MiFID) crystallizing into regulations, participants are also being directed toward the same model. SEFs are differentiating themselves by offering both request for quote or closed limit order book methods of trading and are partnering with the larger central counterparties (CCPs) to ease margin management. Interestingly, some are offering electronic interfaces that offer the ability to trade swaps, as well as more traditional instruments that can be used to hedge them. This one-stop approach will open up automated arbitrage approaches.
In addition, the buy side is increasingly adopting algorithmic trading tools, paired with SORs, in order to monitor spreads and execute when they reach a certain threshold at an optimal venue.
Moving forward, the agency trading model is likely to become the norm for OTC transactions globally in the banking sector. In the U.S., the direct agency model is already underway. As the agency model develops, more automation will be needed, making order management essential for optimizing flows and cost structures.
In order to keep up with evolving market practices in OTC derivatives trading, firms need software to manage these flows electronically, price contracts, and increase transparency around position keeping. Automated connectivity, real-time valuation and rules engines are especially critical for those taking positions in these products. In an unpredictable market, embracing new technologies can help firms adequately prepare for change.
-Tim Dodd is head of product management for SunGard's Front Arena.
To find out more about the changing world of OTC derivatives central clearing read the whitepaper "The New World of Central Clearing".