Swaps fragmentation begins to subside

IFR 2050 13 September to 19 September 2014
3 min read
mike kentz

The fragmentation of liquidity in certain OTC swaps contracts across national borders may finally be subsiding, a year after Dodd-Frank regulations first pushed European market participants away from their US counterparts.

International clients are slowly beginning to warm to the idea of trading on swap execution facilities after having avoided the platforms for the past year, according to platform operators.

“One of the more recent changes we’ve seen is that the fear of SEFs internationally is fading,” said George Harrington, global head of Bloomberg’s fixed income trading business on a panel at ISDA’s North American General Conference last Tuesday.

“Our international clients wanted to stay off-SEF initially because they were worried the reporting requirements would mean the whole market could see their positions…but over the past six-to-nine months they’ve realised the risk that your activity is easily discoverable is less than originally thought.”

Harrington cited the fact that many of the swaps currently trading on SEFs are liquid enough that transparency is not posing any real threat. Further, swaps users can trade in blocks that are afforded a slight reporting delay.

If international firms do migrate onto SEF it would represent a major step towards the harmonisation of regulatory regimes seeking to implement G-20 reforms at different paces. European officials are in the process of implementing rules for trading on registered platforms while the US has been up and running for just under a year.

The staggered schedule has led to claims of liquidity fragmentation in the euro-denominated interest rate swap market, in particular.

Falling volumes

An ISDA study from June stated that the volume of euro IRS transacted between European dealers and US dealers as a percentage of total volume had dropped from 25% prior to the launch of SEFs last October to 6% at the end of May.

Volumes between US and European dealers have shrunk from approximately US$700bn per month prior to October to under US$200bn at the end of May, according to ISDA data.

The fragmentation is a bothersome side effect for some who hoped G-20 regulations would finally coalesce the global swaps market.

“For me, I don’t want to go from one dual market structure [where inter-dealer markets are separate from buyside markets] to another,” said Michael O’Brien, global head of trading at Eaton Vance, speaking on the panel. “Our hope is that we have one global pool of liquidity.”

The change highlighted by Harrington is also coming at a key juncture for G-20 implementation as US and European regulators spar over the recognition of each other’s clearing rules.

The differing execution standards that caused the fragmentation in the first place resulted from a political battle between US and European regulators last summer – a process that many feel has been mirrored this summer in the clearing debate.