The Dodd-Frank requirements for SEFs ushered in a new wave of market technology and big changes to market structure. For firms that have been willing to participate, and quick to adapt they are seeing volumes increase on the exchanges as well as more streamlined trading.

SEFs: Surprisingly Useful Despite Detractors

By Sol Steinberg

The Dodd-Frank requirements for SEFs ushered in a new wave of market technology and big changes to market structure. For firms that have been willing to participate, and quick to adapt they are seeing volumes increase on the exchanges as well as more streamlined trading.

SEFs allow for compression, which can eliminate offsetting trades, thereby reducing risk and cost while also freeing up available credit. With trade compression dealers remove trades that are equal and offsetting which leaves fewer orders remaining in the system. This practice cuts down risk and also improves overflow. As SEFs have started to mature, trade compression is becoming a more common part of derivatives trading. Since November 2013, some $850 billion in compression trades have been executed through the Tradeweb SEF alone. Similar figures are found throughout the industry.

A compression platform gives buy side participants specifically, the opportunity to more effectively manage their balance sheets and maintain more dynamic positions over the course of several trades or a trading cycle.

Institutions too, are getting in on the action through SEFs. Early on critics of the SEF framework suggested that institutional investors and large non-financial companies would only enter the swaps market on a one-off basis going forward as the costs would be too high. Instead, these groups are entering the market regularly as part of their hedging programs.

Alongside the trade compression enjoyed by investment managers themselves, investors can now package trades on SEFs allowing for greater efficiency. Package trades allow investors to consolidate two or more trades into one transaction which can cut transaction costs. Making the trades together can also reduce the possibility of price moves before all of the trades have been completed, diminishing basis risk and ensuring the integrity of an investment thesis.

Instruments that benefit both investment managers and investors are also quickly coming to market as SEFs mature. Market agreed upon coupon (MAC) swaps are one example. MACs were introduced by Sifma’s Asset Management Group, in conjunction with the International Swaps and Derivatives Association, as a new interest rate swap contract structure with pre-defined terms. The point of these swaps is to provide greater liquidity in the interest rate swaps market. MAC swaps have standardized dates and a fixed, standardized rate which allows them to be collapsed into a single line item at the clearinghouse. This provides players with a liquidity solution and only one line item in a portfolio over ‘plain vanilla’ swaps that don’t collapse in the same way.

These new offerings are increasing in volume as players realize the options available to them for mitigating risk and ensuring liquidity. When used effectively, MAC swaps can provide the same basic exposures as vanilla swaps but with less complexity.

Growing pains

Still, challenges remain. There are a handful of technological risks facing dealers that were created as part of the SEF mandate and will require market participants to work through with regulators and clients. The CFTC appears to be cognizant of many of these issues and has already extended compliance guidelines for several facets of the SEFs regime.

Yet, Dodd-Frank requires a certain level of immediacy in terms of pushing swaps onto an exchange-style market. However, the regulation does not include a best execution scheme which has created a fragmented market structure. This structure means that both buy side and sell side participants have to monitor multiple SEFs looking at pricing and volumes. This represents a significant adaptation for swaps participants in terms of building out their own technology to manage multiple feeds of information.

Some types of firms are better at this than others. High Frequency Trading (HFT) and “Chicago style” traders have tech savvy embedded in their practices and have been quick to adapt to the technology changes required by Dodd-Frank. This can mean that more traditional organizations can be trading at a slight disadvantage while they learn the ropes.

Reaction to this new reality has been mixed, and surprisingly, traditional mutual fund firms and the buy side have joined forces when it comes to pushing the CFTC for changes to the regulatory structure.

Historically, the swaps market was a closed and invitation only market that largely transacted over the phone. Trades were handled generally anonymously aided in part by the phone-based nature of swaps before Dodd-Frank. Now, as these trades move to “lit” exchanges, trades are obvious and names are given up in the execution phase.

Market participants say the practice of giving up the price of the trade as well as the counterparties involved is fueling bifurcation in the market and adding unnecessary complexity. Notably, blue chip hedge funds like Citadel and D.E. Shaw are teaming up with more traditional firms like Eaton Vance to ask the CFTC to bring back at least a measure of anonymity.

Hedge funds want to be able to trade on the same platforms as banks without having to say who they are. As it stands now, Banks can see not only the price of the trade as well as who is behind it. This reality gives banks the option of trading among themselves on one tier of the swaps market and trading among their clients on another tier. Hedge funds and mutual funds alike say this reality works against the idea of fairness stated in Dodd-Frank.

Banks, for their part, say that bringing back anonymity would create a separate set of issues for packaged trades were counterparty risk is more complex and parties need to be disclosed.

Looking ahead

The debate happening among financial firms about anonymity isn’t happening in a vacuum – the CFTC is listening and making its own comments.

Earlier this year, CFTC Commissioner J. Christopher Giancarlo released a white paper on swaps trading rules that proposed significant changes to the SEFs regime. In the paper he said that his proposal would bring the regime more in-line with the original intent of Dodd-Frank.

Under the current regime, SEFs are somewhat restricted in how they can operate in terms of liquidity. This reality may be pushing some participants away from using SEFs which works at cross purposes with the intent of the regulation. The market fragmentation alluded to above has also sent some participants to overseas markets which aren’t subject to the SEFs regime. Liquidity pools are also separating US and non-US persons, adding another layer of fragmentation and market risk.

The paper also noted directly that the regulator was aware of the name give up problem asserted by hedge funds and mutual funds. In his discussion, Giancarlo wonders aloud about how liquidity might be repriced or even removed in an anonymous market.

The paper signals that the CFTC is taking a close look at how the SEFs regime has been implemented and taking stock of what works and what doesn’t. Giancarlo stepped into the debate proposing a package of reforms and refinements that could have a significant impact on the industry. Other commissioners however, have been slightly more measured in their responses. CFTC Chairman Massad has said publicly that he thinks the SEF rules deserve further examination but hasn’t made a significant move toward any specific changes.

Until new rulemaking comes to the fore, the CFTC has been steadily issuing no-action letters on a range of issues. While these letters are situation specific, examined in aggregate they can provide a view of where the regulator may be heading. The CFTC has also held several public roundtables on the SEFs regime. Taken together, market participants may do well to keep an eye on these items until a more codified change to the rules comes about.

This article was first published in edition 4 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to receive the latest hard copy editions as they become available.