Written by Jim Myers, Kimon Mikroulis and Paul Gibson of Sapient Global Markets
SEF trading and the “electronification” of the OTC marketplace are still in their infancy. From the SEF trade volumes published to date, it seems likely that established interdealer brokers and firms with significant pre-SEF volumes appear poised to ”win” the first phase of mandatory SEF execution. Newly established SEFs have struggled and will be forced to specialise, differentiate and innovate with value-added offerings.
There is a significant likelihood that many former dealers will increasingly depend on a more fee-based revenue model, which could include charges for execution, connectivity, clearing and collateral management services.
One key trend to observe over the coming months, alongside SEF aggregation and new business models for banks, is the convergence of OTC and exchange-traded derivative (ETDs).
There is a view among some market participants that demand will shift away from OTC trading on SEFs due to increasingly onerous regulatory requirements and move toward ETDs, specifically swap futures. Swap futures are designed to mimic standardised OTC swaps but have reduced margin requirements relative to cleared swaps.
While there has been an increase in the volume of swap futures, this trend does not necessarily reflect a wholesale shift away from OTC products. In fact, results from ISDA’s recent survey of 245 market participants on the economic value of OTC derivatives imply they are becoming a more popular form of risk management: 80% of respondents expect to use them going forward. In this context, the differences between OTC swaps, swap futures and other exchange-traded derivatives are significant.
Among the most important are the hedge accounting rules, which are commonly used by swap users to mitigate undesirable earnings volatility caused by mark-to-market valuations. This relief to the mark-to-market rules is only available if the hedging party can clearly document the ability of the hedge to mitigate an actual risk.
With the standardisation inherent in a swap futures contract, the risk mitigation argument is significantly more difficult to make due to a standardised contract’s inability to mirror the precise risk factor.
Additionally, there is significant uncertainty around the way in which the IRS will treat these futurised swaps for tax purposes. These differences, along with the uncertainty around the long-term regulatory treatment of swap futures, have proven to serve as a disincentive toward broader and faster adoption of swap futures products.
Price discovery on SEFs can occur through a request for quote (RFQ) or central limit order book (CLOB). To date, the vast majority of current SEF volume is conducted using the RFQ methodology, which is relationship based and follows an on-demand market-making principle. CLOBs, which are common in the ETD and equities world, are characterised by a continuous stream of prices on both sides of a market. CLOBs are common in products with high volumes and liquidity.
At this point, it is unclear as to the role that CLOBs will play in the evolution of the SEF markets. In the listed space, quotes of small notional value are often streamed into a CLOB. As a market participant seeks to execute a transaction, he or she would submit an RFQ. As other market participants respond to the RFQ, the width of the market would tighten and the size available to trade would increase. This is a likely first step in the creation of a CLOB on a SEF.
With their unique market structure, SEFs can connect to multiple CCPs and market participants can connect to one or more SEFs either directly or through an FCM. Given that products are fungible on the CCP level, the choice of SEF is unimportant. Over time and as market participants get over their initial frantic onboarding to SEFs, best execution in terms of price will become more important, as will terms common in listed products, such as the width and depth of the market. The SEFs able to foster the creation of these “best markets” will be the long-term winners in the space.
The single largest area of convergence may well lie in the impact of electronic trading on the OTC market. While mandatory electronic trading is still in its infancy, there are some signs that those familiar with the transition to electronic trading in the listed space will recognise.
New entrants and former market takers who have not previously acted as OTC market makers are beginning to change the market and bring their own version of aggressive market making, speed and risk management to bear. Market takers are increasingly requesting RFQs from the entire market and not just from those dealers with whom they have prior relationships.
There has been evidence that some traditional buy-side firms have been actively “making markets” for other buy-side firm’s RFQs resulting in a new “all-to-all” market paradigm. Many market participants are anticipating continued rapid evolution over the course of the next twelve to eighteen months.
Jim Myers is a senior manager of business consulting based in Chicago, Kimon Mikroulis is an associate and Paul Gibson is a business consultant, both based in London at Sapient Global Markets.