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2011 to be a Defining Moment for Swap Execution Facilities

Industry players are jockeying for position to compete as Swap Execution Facilities (SEFs). But regulators are still writing the rules.

Why It's Important: Swap execution facilities, or SEFs, represent one of the biggest opportunities to come out of the new Dodd-Frank requirements for OTC derivatives. The new law will require many types of swaps to trade on an exchange or SEF, and then to be cleared through central clearinghouses. While bulge-bracket brokers have dominated the OTC derivatives markets for years, SEFs will open up access to the swaps trading business to new players. Already, dealers, interdealer brokers (IDBs), exchanges, alternative trading systems (ATS) and others are looking to position their firms as players in the SEF space. Each SEF must provide transparent price discovery and ease of execution to market participants, as well as open access to regulators, explains Lloyd Altman, senior executive in Accenture's capital markets practice.

Where the Industry Is Now: The SEC and CFTC are writing the rules for the SEFs, including a definition of an SEF and guidelines on which market participants get to operate them and which products in the various asset classes will trade on SEFs. "We will be waiting for the CFTC and SEC to tell us which products are mandated for clearing and traded [on exchanges or SEFs]," says Kevin McPartland, senior analyst at Tabb Group. The initial focus is thought to be on moving interest rate swaps and credit default swaps onto SEFs, followed by equities, foreign exchange and energy swaps. There is concern that dealers that operate clearinghouses could show preference for their own SEFs, so the CFTC is looking to place constraints on dealer ownership of the facilities, which could force dealers to spin off their SEFs or take on outside investors.

Focus in 2011: Regulators will complete the rule-making process, establishing guidelines and legal structures for the execution process, the SEFs themselves and central clearing. According to a recent Tabb Group report, as set forth by Dodd-Frank, final rules that take the industry's comments into account must be in place by July 15, 2011. To meet that deadline, regulators have said they are seeking to post draft rules for SEFs, among other issues, by mid-December. But regulators also have to decide on the market structure of the SEFs. While exchanges match continuous bids and offers and have open order books, the OTC derivatives legislation, which is vaguely worded, may allow for different models. While many existing platforms use the request-for-quote (RFQ) model, the CFTC wants participants to have access to multiple bids and offers from multiple participants and could dictate the price discovery process. "There's even talk that the RFQ market that's been used everywhere for swap platforms wasn't allowed," says McPartland.

Industry Leaders: A large group of the top dealers -- including Barclays, Citigroup, Credit Suisse, Deutsche Bank and Morgan Stanley -- are looking to form SEFs to retain their liquidity in the swaps game. And exchange operators, such as CME Group (which owns NYMEX Clearport) and Intercontinental Exchange (which owns CreditEx), are expected to register as SEFs. Other exchanges, including NYSE Euronext, which owns New York Portfolio Clearing and NYSE Liffe, and the ELX Futures Exchange also are expected to contend in the SEF space. Meanwhile, existing platform providers Tradeweb, Market Axess and Bloomberg have said they intend to register as SEFs as well, and interdealer brokers BGC Partners, GFI Group, ICAP, Tradition and Tullett Prebon also have said they will launch SEFs. Newcomers that could compete in the space include the Eres Exchange, a platform for trading interest-rate swaps backed by five automated market making/high-frequency trading firms.

While initial SEF registration likely will hover around 15 participants, according to McPartland, he estimated in the Tabb report that 20 to 30 SEFs ultimately will come online by 2012. He predicts that one-third of the SEFs will come from the IDBs, one-third will be run by the exchanges, and one-third will be a combination of existing platforms and new entrants.

Technology Providers: Connectivity will be essential for SEFs to hook into clearinghouses, market participants and data reporting repositories. "Standard, extensible application programming interfaces [APIs] such as FIX and FpML will be the bedrock of how market participants interact with SEFs," says Accenture's Altman. "Live streaming market data from the SEFs that market participants will need to feed to their decision support systems should be available via FIX Market Data messages or integrated with standard feeds provided by companies such as Thomson Reuters."

Price Tag: While the rule-making process is ongoing, dealers already are spending millions on technology, including turning their platforms into SEFs, to retain their liquidity in the new regulatory environment, according to the Tabb report.

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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