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Could SEF Aggregation be the Next Big Thing in Swaps?

With SEF trading becoming mandatory on Feb. 15 for certain interest-rate swaps and continues to evolve, industry watchers are waiting to see if SEF aggregation will emerge to help the buy side connect with multiple SEFs.

As the final countdown for SEF trading winds down, buy-side firms are gearing up for the mandatory execution requirement for any class of swap that has been certified through the regulatory process.

On Friday, Feb. 15, Javelin SEF’s made available to trade (MAT) agreement, triggers the trade requirement for certain interest rate swaps, followed by TruEX on Feb. 21, and TW SEF (Tradeweb) on Feb. 27. MarketAxess’s MAT is already determined to be MAT because it contains CDS that are already certified by a previous (TW SEF) MAT. Bloomberg's MAT determination is expected to be certified this week.

Within the next two weeks, tranches of interest rate swaps and the most liquid credit-default swap (CDX) indices (CDX.NA.IG CDX.NA.HY as well as the iTraxx Europe CDX and iTraxx Europe Crossover 5Y) will be required to trade on SEFs or designated contract markets (DCMs).

Some industry watchers say it’s still uncertain as to how the market structure will evolve in terms of the buy side connecting to the various SEFs or whether a different model will emerge.

“I think it could evolve in a number of ways. We could see a sponsored access model where an FCM is going to connect to a variety of SEFs and allow their customer to connect with them,” said Jim Myers, senior manager, Sapient Global Markets. “We could see a sponsored access model, where an FCM is going to connect to a variety of SEFS and allow their customer to connect with them. The end user would then onboard to the SEF, but they would have a clearing relationship with the FCM,” Myers explained.

One of the hot topics is the potential for SEF aggregation whereby a buy-side firm could connect to a single platform that will compare prices across the entire SEF market. This would save firms the trouble of connecting directly to say six SEFs. Another model already prevalent in fragmented equities markets, that could emerge is the smart order router, which is through software installed on the trader’s desktops that would decide where the trade is going to be routed.

There are diverse opinions on which models could work but the new swaps market structure is going to evolve for another 12-to-18 months before it’s known and it could continue to take even longer, suggested Myers.

While it’s unknown if SEF aggregation is going to be the next big thing, according to Myers, Swapshub is a standalone platform and is trying to hook up to all the SEFs. “This would be a pure play on aggregation,” said Paul Gibson, business consultant, Sapient Global Markets. Other software companies, which are not marketing themselves as SEF aggregators, per se, already offer similar services in other markets, such as Ion Trading, FlexTrade Systems, icubic AG, SmartTrade Technologies, added Gibson.

“I think the recurring theme is that none of us quite know what is going to happen,” said Myers. Everybody is trying to research the recent past electronic transformation of markets in equities, futures and equity derivatives,” he said. Then there are interdealer brokers (IDBs) “which are going to differentiate themselves by maintaining the voice functionality they’ve had for the last 40 years,” said Myers.

One of the issues is that some of the new SEFs are struggling to gain traction, but now that trading on SEFs will be mandatory for some of the most liquid swaps, they are in a better position to attract buyers and sellers.

“What’s for sure is the buy side in the US are going to have to trade on these platforms. There’s no way to avoid it,” said Gibson.

Dealer to client (D2C) activity in particular saw marked increase in the past two weeks, according to Clarus Financial Technology, so the buy side is on-boarding as the MAT dates draw closer. Meanwhile, interdealer brokers (IDBs), including ICAP, Tullett Prebon, Tradition and BGC Partners have the most liquidity.

International banks could avoid SEFs by going outside the U.S. There is anecdotal evidence that some traders have moved their locations to London and are trading with European counterparties to avoid the reach of the CFTC, he said.

“The key is where is the liquidity? Where are you able to get the tightest deepest markets, and that’s the one thing they don’t talk about a lot in the OTC world,” said Myers, who noted this has been more of a gentleman’s game based on relationships. But they may not get the best price, said Myers, adding that a centralized [SEF] is going to attract more people to show up to trade the product.

“The buy side is still in a scramble mode to try to adapt their current operations to the SEF reality and they’re not really worried about getting the best efficiency at this point,” said Myers.

But best execution is going to matter after the MAT dates and once these SEFs are tested and people are on-boarded to them,” he emphasized.

“As soon as the buy side sees that perhaps MarketAxess has a better market in credit and TW has a better market in rates, they will start thinking about how to get better execution,” predicted Myers. “And, when those efficiencies come in, that’s when you are going to see things like smart order routing or trade aggregation happen,” said Myers.

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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User Rank: Author
2/14/2014 | 4:18:32 PM
re: Could SEF Aggregation be the Next Big Thing in Swaps?
On a positive note, SEFs like Bloomberg and Tradeweb have announced trades completed by buy side firms and FCMs via sponsored access in the past few days. This will help the buy side transition to the new market structure and grow the liquidity of SEFs.
User Rank: Author
2/13/2014 | 3:39:22 PM
re: Could SEF Aggregation be the Next Big Thing in Swaps?
The new market structure for swaps is complex and there are a lot of compromises that were made by the industry and regulators. It will take time for the industry to transition to the new ecosystem of SEFs, sponsored access and hybrid or voice/brokerage platforms. Here's one fun act: did you know that the current made-available to trade (MAT) determinations only cover T+2 instruments. That means the day after the instrument is traded (T+1) it is no longer a required transaction; it falls into the preferred transaction category. Now this instrument can be traded on a SEF (optional) or by any means of interstate commerce. I assume most highly liquid, benchmark swaps will continue to be traded on SEFs for consistency and STP.
Greg MacSweeney
Greg MacSweeney,
User Rank: Apprentice
2/13/2014 | 12:44:04 PM
re: Could SEF Aggregation be the Next Big Thing in Swaps?
Very well put. You could probably say the same thing about most recent regulations that have touched on market structure. The competing demands of regulators, politicians, industry lobbyists always seem to conflict.
User Rank: Author
2/12/2014 | 8:28:39 PM
re: Could SEF Aggregation be the Next Big Thing in Swaps?
It's amazing to me after a half century of studies of market infrastructure that we had the opportunity to take those lessons and apply them to this new regulated listed market and didn't. We are all to blame - regulators who wrote rules to meet deadlines when they did not understand market practice or market mechanism. Industry participants who went along when they knew how dysfunctional the regulations were and still are. Our politicians who told us they solved our problems. And the technologists who knew and know, after all they have to implement this, and failed to speak up.

Pause, put the plumbing in place first from lessons learned, then let the SEFs plug in and compete on a level playing field. A plan!
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