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SEF Consolidation Likely as Volumes Slowly Increase

With 21 swap execution facilities, and slowly increasing volumes, the marketplace is perfect for consolidation.

It’s been a quiet summer for swap trading venues. SEF trading has been mandatory for many over-the-counter derivatives, mainly credit indexes and interest rates, since mid–February. Yet the transition from opaque voice trading to SEFs (swap execution facilities) has been evolving slowly.

While 21 SEFs, including big players and startups, have registered with the Commodity Futures Trading Commission (CFTC), analysts are predicting that a wave of consolidation may hit the sector over the next year.

In a recent second-quarter earnings call, Rick McVey, CEO of Market Axess, whose SEF is among the leading players in credit derivatives, commented that volumes had increased as compared to the first quarter, but it was not enough to make the SEF business profitable. “Aggregate CDS SEF volumes are lower than expected, and regulatory costs to operate SEFs are far greater than current SEF revenues,” McVey told analysts during the July 23 earnings call.

Analysts say it's too early to pick winners and losers because trading on SEFs didn’t become mandatory until mid-February and because package trades didn’t begin to phase in until mid-May. “Because there is so much of the market that isn’t on SEFs, we can’t say definitively somebody has ownership,” says Kevin McPartland, head of market structure research at Greenwich Associates. “Many don’t believe the infrastructure is ready,” although the industry has “certainly made big strides.” In addition, some funds whose legal entities are based offshore, are declaring themselves non-US, which enables them to trade off SEFs.

SEF Volume
SEF volume for the week of June 23-27
SEF volume for the week of June 23-27

Buy-side firms could be staying away for a few other reasons.

“From a compliance perspective, SEFs have only been given temporary approval by the CFTC,” says Will Rhode, global head of capital markets research at the Boston Consulting Group. At the same time, SEFs are many and varied, in that some are interdealer brokers, others are dealer-to-customer electronic platforms, some are created by exchanges, and others are startups.

Incumbents get bigger
So far, the largest players, namely Bloomberg and Tradeweb, are capturing the most market share, much more so than startups.

Bloomberg’s SEF had 83% share of the notional volumes in credit index derivatives in July, while Tradeweb had 8.23%, ICE had 4.2%, and MarketAxess had 2.4% of notional volume, according to Clarus Financial Technology.

From Aug. 1 through Aug. 12, Tradeweb garnered 13.3% of interest rate derivatives volume on D2C platforms, while Bloomberg had 20.2%, according to Clarus.

“Bloomberg and Tradeweb were the primary dealer-to-customer venues in the pre-SEF world and are still doing the bulk of the dealer-to-dealer SEF volumes as well,” noted an industry observer who spoke anonymously.

“Bloomberg is doing quite well. Their fee structure is very low and straightforward, and the market seems to like their model,” says McPartland of Greenwich Asssociates.

Some sources cite Bloomberg’s low-cost pricing model for SEF trades: It charges $10 per SEF trade, which is magnitudes less than its electronic rivals. Bloomberg is able to leverage its dominant position on the trading desktop.

“Bloomberg runs its SEF as a utility. They’re already in the workflow and on the desktop; they already are a known entity,” said an industry source, who requested anonymity. “Bloomberg may not see the SEF as a revenue stream, but see it as strengthening its value proposition of selling data and terminals,” the industry source suggests.

Another factor in the mix is that central clearing and electronic trading under Dodd Frank is more expensive for the buy side. “One of the major changes for the buy side is they used to pick up a phone and ask for a price and execute for free. There was no explicit fee for execution. Now, with SEFs, there is,” says Rhode.

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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IvySchmerken
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IvySchmerken,
User Rank: Author
9/2/2014 | 9:09:47 AM
Re: Trade Compressions
You raise an interesting question: I am not sure of the difference between portfolio compression at the SEF level and how that works differently from portfolio compression at the clearing house level. I would assume that at the SEF level, portfolio compression is netting/terminating the positions that someone has at a particular clearing house against positions held by users of that same SEF. Perhaps trade compression at the clearing house level more broadly includes users across all SEFs that have positions at a given clearing house?


According to a February 2014 report from ISDA focused on interest rate derivatives" 

...significant progress has been made in reducing the size of the market through portfolio compression. Compression has helped to reduce the IRD notional outstanding by approximately 30 percent since 2009.

 

 
kiranpawar
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kiranpawar,
User Rank: Apprentice
8/29/2014 | 7:11:43 PM
Trade Compressions
Interesting to watch SEF platforms offering trade compression feature. How would that work in tandem with CCP compression services?
IvySchmerken
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IvySchmerken,
User Rank: Author
8/27/2014 | 10:39:17 AM
Re: Consolidation surprises?
There could be surprises during the consolidation wave. Perhaps some of the exchanes will acquire some of the SEFs? I don't think any startup SEF with low volume is going to have an easy time grabbing market share from a larger, established SEF. We have seen Bloomberg and Tradeweb take teh lead in the D2C [dealer to client space). Both have large distribution on the buy side and connectivity to dealers, swap data repositories (SDRs) and central clearing counterparties (CCPs). This is not to say that someoe else, including a start up can't make inroads into their market share. I think if a startup has deep pockets or gets a consortium to buy into them, they could grab share but will need to offer value-added functionality and/or  slash fees.
IvySchmerken
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IvySchmerken,
User Rank: Author
8/27/2014 | 10:13:24 AM
Re: Buy side fees
Buy side is getting transparency into pricing through the SEFs. Each SEF has an order book and posts bids and offers. The CFTC is also requiring the buy side to get three prices via the RFQ (request for quote) method. This is up from one quote previously. However, institutions sometimes want to trade with one dealer to prevent information leakage. The more prices they request, the more they raise the chance of price leakage. Although they want the best price, they may compromise to keep their trade confidential.
IvySchmerken
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IvySchmerken,
User Rank: Author
8/27/2014 | 10:09:46 AM
Re: Buy side fees
Yes, the SEC is pushing for more transparency into the corporate bond market for retail investors and institutions. They have post-trade transparency through the TRACE feed so they can see the last trade. But investors also need pre-trade transparency.
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
8/26/2014 | 5:54:50 AM
Re: Buy side fees
Yes, I think the buy side knew, but the transparency into pricing is vital for any market to succeed. There have been too many instances with opaque markets that eventually cause problems.
senthilr14
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senthilr14,
User Rank: Author
8/25/2014 | 12:24:04 AM
Buy side fees
What is important is not about Buy-side paying a fee for a SEF trade, but Buy-side having more visibility on the price of instruments and paying less overall. Earlier I wonder if they really knew that they were getting the best price.
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
8/22/2014 | 7:09:16 AM
Consolidation surprises?
I wonder if there will be any surprises during the consolidation wave that will likely come. For instance, will a low volume, but well funded start up or new entrant in the market make an attempt to grab the business of a larger volume SEF from a company that may not really want to be in the SEF business? It could get interesting.
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