Up to three-quarters of interest rate swaps executed by US buyside firms are being structured in a way that avoids Dodd-Frank requirements for trading standardised derivatives on exchange-like platforms.
Through forward and backward-starting structures whose terms reference maturities just a few days or weeks off the standard benchmark tenors, the majority of dealer-to-client interest rate derivatives activity continues to be executed on an over-the-counter basis some six months into mandated trading of standardised contracts on swap execution facilities.
“Three-quarters is a believable guesstimate of how much client business is not hitting SEFs,” said Tod Skarecky, senior vice-president at ClarusFT, a data and analytics firm. “The raw data are not explicit enough to come to firm conclusions, but using a series of debatable assumptions, one can arrive at an estimate in this neighbourhood.”
Those estimates are based on an assumption that the entire 35% of IRS activity that is either forward or backward-starting, represents dealer-to-client trades, while all dealer-to-dealer activity is benchmark in structure.
Although non-benchmark structures have been viewed by some participants anxious for meaningful change as a useful avoidance tactic, for many buyside firms the shift towards SEF trading has not been straightforward for an array of legal, operational and regulatory compliance reasons.
But six months on from the mandate, platform operators argue that the time for excuses has long passed.
“Meaningful change in financial trading sectors historically only happens when the buyside actually changes their workflow. Dealers are then forced to adjust accordingly,” said Wally Sullivan, CEO of Javelin Capital Markets, a newcomer SEF.
“As with other asset classes, there comes a time when traders should consider experimenting with new workflow options that could lead to significant long-term cost savings by eliminating information slippage as much as possible.”
If the market continues to shuffle its feet in making the switch, SEFs themselves could force the issue. Under CFTC rules, SEF platforms have the power to mandate the rest of the IRS curve for SEF-trading through a “made-available-to-trade” application.
Eventually, participants expect a MAT filing will include the tricky forward and backward-starting swaps, ultimately eliminating what some view as a work-around of the new rules.
From the outset, many fund managers complained that SEF legal agreements were one-sided, affording platform operators auditing rights over their fund manager clients, and access to investors’ books. Further, funds are reluctant to comply with onerous swap data reporting requirements that come with signing up for direct membership on a platform.
But the emergence of dealer-run agency execution platforms such as UBS Neo, Credit Suisse Prime, and Morgan Stanley Passport are helping to alleviate those concerns. The platforms lift responsibility from the buyside for the reporting of swaps data and act as a go-between for SEF auditing needs.
Neo is currently the only one of the three up-and-running, but sources say Prime and Passport are slated for a full launch before the end of the year.
However, the latest attempts to iron out operational and legal concerns may not be enough to boost flagging SEF volumes, as some believe the figures reflect a dealer-led bid to keep buysiders off order books for fear that income streams will be hit as the information advantage is eroded.
According to some industry observers, buyside firms have been reluctant to enter the SEF space as they may be risking the favoured customer status that typically benefits them with exclusive information and improved pricing.
“They [dealers] don’t directly come out and say that you’ll be cut off if you enter the order book, but they will say that if you enter the order book they can’t guarantee to be there for you when the time comes,” said one consultant familiar with the discussions.
Any attempts to keep buyside firms at bay are likely to prove futile in the long term as many have already taken important steps towards direct SEF activity.
KCG Partners, Virtu Financial, and Citadel Securities have all made public their intention to make markets in OTC interest rate swaps. IFR reported in June that Citadel became the first non-dealer entity to trade swaps on a SEF order book when it executed on ICAP’s i-Swap platform.