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Will SEFs Increase Market Fragmentation?

Some firms see opportunities in electronic trading, while others express concerns about liquidity fragmenting across swap execution facilities, according to executives at TabbForum event.

Fixed income executives at the likes of Goldman Sachs, BlackRock and Getco, among others weighed in on the outlook for electronic trading and central clearing at yesterday's TabbForum conference. But they also debated whether liquidity would increase or become fragmented among the various swap execution facilities (SEFs).

lsaac Chang, global head of fixed income at GETCO, said there is an opportunity for a firm like his to participate as a liquidity provider. "A good outcome of all this would be a net increase of liquidity because of an increase in a more diverse participation," said Chang on the panel.

But Chang also said the industry could see a bifurcation between benchmark instruments such as interest rate swaps and credit default swaps that are actively traded and other instruments. Chang said there is talk of an agency routing business model -- where brokers execute trades on behalf of clients without acting as a market maker -- which would be new in the fixed income space.

Donald Wilson, Jr., founder and CEO of DRW Trading Group, a player in automated and high frequency trading, said that all of the evolution is going to be an incremental process. "It's not like someone is going to flip a switch," added Wilson.

But throughout the four-hour event there was debate as to whether the regulatory mandates for electronic trading under Dodd Frank would lead to an increase in liquidity.

According to a Tabb Group research poll, 72 percent of the responders said that swaps liquidity would eventually improve under Dodd Frank, while 28 percent said it would not improve liquidity.

But Dodd Frank is not the only reason that automation is coming to the yield curve. Wilson noted that Basel III keeps the focus on standardization of instruments so there is more interest in futures trading. As swaps become centrally cleared, some clearinghouses may accept futures trades, said Wilson noting the benefits of cross-asset margining. Wilson noted that the Eris Exchange would have margin offsets with Eurodollars starting in March.

Meanwhile, buy side firms are also preparing for electronic trading and central clearing. "We are going through a period of innovative disruption," said Supurna VedBrat, co-head-market structure and electronic trading at BlackRock, who spoke on a panel.

BlackRock, the world's largest money manager, is strategically partnering with all major trading venues, SEFs or exchanges, said VedBrat, citing Eris which is a futures-like trading platform for interest rate swaps. But the buy-side giant is talking to every one in the market including the dealers. "We don't know what the future is going to be in swaps market," said VedBrat. In spite of the uncertainty, she is anticipating that BlackRock will probably connect directly with venues and utilize some of the aggregators (i.e., Bloomberg, MarkitServ) that will connect and route orders to the SEFs and clearinghouses. But for the aggregators to be successful, VedBrat said, "There is a need for an agency model, and the rules we currently see don't necessarily support an agency model," she cautioned.

In a second panel, discussion shifted to the credit markets beyond corporate bonds, such as CDS. Kevin McPartland, Tabb Group's head of fixed income research, asked panelists if trading was going to go from a conversation on the phone to algorithmic trading? This depends on the trade frequency, depth of market and number of participants, according to Biswarup Chatterjee, Citigroup's global head of electronic trading, credit markets. "You can't pigeon hole credit markets into one solution. The best method is flexibility," said Chatterjee.

Participants expressed concern that electronic trading was being forced on certain fixed income sectors that were less liquid and some said that voice brokers would still play a role.

Among the other concerns were whether the credit markets would become more equity-like with multiple venues, dark pools and fragmented.

"It's not all gloom and doom that you introduce SEF trading and you see liquidity dry up. There may be players that didn't like the clearing risk (before)," said Chatterjee, suggesting that central clearing could open the door to new participants. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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