In the piece I recently published on this topic , a number of sources argued the over-the-counter derivatives market is likely to fragment once these instruments move onto swap execution facilities under Dodd-Frank. I was also told by an industry source that finding liquidity could be problematic in the new landscape, and that quality aggregation tools will become a necessity.
Another source, meanwhile, argued that derivatives trading will eventually function much like the equities world, where smart order routers are required tools of the trade.
However Sean Owens, director of fixed income research at the advisory firm Woodbine Associates, disputes these views. He contends that while liquidity aggregation tools will indeed be used in the new landscape, their importance may have been a bit overstated by my sources.
"Yes there will be some aggregation, but it is highly unlikely that 10 SEFs will survive for any asset class - a few will get the lion's share of liquidity and likely dominate," Owens wrote in an email. "The sell side will likely tie in to SEFs through their in-house electronic platforms to make markets in the generic structures."
Owens added he "seriously doubts" we'll ever see smart order routers in swaps trading like we do in equities, since traders "will never need to execute the same volume of transactions that you do in the equity markets to get the position or risk you seek. The size will never get that small where it will be relevant."
If fact, the so-called smart order routers in the new marketplace are likely to be humans. And in the long run, this market may not get as complicated as my sources suggested, according to Owens.
"You will likely have two central counterparties (CCPs) per asset class clearing all standard trades," Owens wrote. "Sell side revenue will come from clearing, flow market making on SEFs or off SEF block trades, and bi-lateral trades for non-standard structures."
As for the buy side, he contends that non-standard trades will be bilateral, the same as they are today. "Standard trades will be executed on SEFs - likely better liquidity since there will be a greater number of liquidity providers quoting," he wrote. "Once traded, a firm's clearing broker will interface with whatever CCP the buy side uses ... allowing buy side firms to be SEF agnostic and clear at their chosen CCP."