As a watershed year for global derivatives reform, 2014 saw one of the most ambitious strands of the Dodd-Frank Act finally come to life. Large swathes of the US$691trn over-the-counter swaps market were pulled out of the OTC shadows and into the bright lights of regulated exchanges.
The first wave of standardised interest rate swaps made the shift to newly created swap execution facilities in February 2014, bringing the US derivatives market a step closer to the vision that G-20 leaders agreed in Pittsburgh almost five years ago.
However, what some regulators envisaged as a big bang was in reality more of a whimper.
Despite covering the four major currencies across all benchmark tenors for interest rate swaps, and the eight key credit default swap indices in the US and Europe, the trade execution mandate caused little more than a ripple across the market.
Volumes stagnated across the 24 temporarily registered platforms offering swap-trading capabilities and, as of the end of October 2014, just US$2.9trn per month of interest rate swaps were trading on swap execution facilities, according to TABB Forum, out of a total outstanding notional of US$563trn.
A market that was touted to explode in 2014 struggled merely to find its feet, intensifying the focus on which platforms would last the course. That question was difficult to call as the absence of a dramatic buyside shift on to SEFs did little to establish any true market leaders.
“When you’ve got this many platforms trying to grab their piece of the pie, clients are confused as to which SEFs to join or trade on, so liquidity may be fragmenting across venues,” said David Lucking, a partner at Allen & Overy. “That undermines the price transparency goals of Dodd-Frank and is negative for customers.”
In reality, there was no dramatic overhaul, just what many see as an electronification of existing market structures. Clients continued to execute through the old request-for-quote mechanism – essentially calling up a handful of banks for prices on a bespoke trade – though those trades were then booked electronically and through the new legal structure.
But headwinds continued to build and the days of the old model were surely numbered. More swaps are due to be forced on to the platforms. For example, packaged transactions – where a swap is combined with another instrument such as a Treasury future – look likely to migrate on to SEFs in 2015.
The spread transactions, as they are also known, were expected to move to SEFs in November, but plans were delayed by the CFTC’s newly appointed chairman, Timothy Massad.
“We recognise the market needs a bit more time on certain remaining packages,” he told delegates at the Futures Industry Association Expo in Chicago just days before the shift took place.
Inclusion of additional products was viewed as a likely tipping point for the struggling platforms. Market participants estimated that up to 20% of the IRS market was executed as swaps plus Treasury futures packages, meaning those instruments managed to avoid SEFs entirely through 2014. However, a later analysis of the market by ClarusFT pinned those volumes closer to 3%.
But a more contentious catalyst continued to lurk behind the scenes. Under the CFTC’s execution rules, platforms themselves – not regulators – were granted the power to force the remaining off-SEF bespoke swaps into the mandatory SEF-trading environment, via the made available to trade requirement.
“The bit about the MAT [made available to trade] application that we have a problem with is that you are mandating it for the whole market,” said Lee Olesky, chief executive of Tradeweb Capital Markets, a dealer-to-client SEF that has so far dominated buyside volumes along with Bloomberg. Tradeweb is part owned by Thomson Reuters, which also owns IFR.
“We don’t really love the idea of a model being used by a regulator where one SEF can set the standard for everyone else,” said Olesky.
The assumption of many market participants is that one of the struggling platforms could file a MAT, forcing more business – and potentially unsuitable products – in that direction.
The new framework levied high costs on the buyside and created new opportunities for dealers and third parties to offer sponsored access by charging clients for access to an array of platforms that would be uneconomical for any buyside firm.
According to an executive at an SEF aggregation platform, clients pay anywhere up to US$50,000 just to review each platform’s rulebook.
Dealers including UBS, Credit Suisse and Morgan Stanley offered such services, but the model remained unproven due primarily to a lack of activity.
“The fact that trading has stayed on an RFQ basis has meant that there is limited client demand for aggregation or sponsored access at this point,” said Stephane Malrait, global head of eCommerce for FX and fixed income at Societe Generale. “That could become more of the norm in the future but right now you don’t need to be able to access multiple pools of liquidity.”
A disorganised CFTC approach to registration only exacerbated the issue. Registrations were handed out on a temporary basis, forcing the agency to review legal agreements for discrepancies, with the added threat that it could hand down rejections at any time.
“It was somewhat unfortunate that the CFTC has allowed platforms to operate without being fully registered, because we’ve seen certain SEFs that appear to be operating without being fully in compliance with CFTC core principles,” said A&O’s Lucking.
“Given the sensitivities and competitiveness around attracting people to your platform, it could be a real advantage to be outside of compliance.”
Because of the inauspicious start, cracks in the system were already showing by mid year.
Two SEF chief executives left their positions. In May, James Cawley left Javelin Capital Markets – the firm he founded – while Tom Zikas parted company with State Street.
Three inter-dealer brokers assigned new CEOs to their SEF subsidiaries, one of which turned out to be Cawley resurfacing at BGC Partners only months after his departure from Javelin.
A number of brokers also began to make discrete overtures to entice buysiders – a risky proposition that ran in contrast to the desires of the core dealer client base.
In June, ICAP – the world’s leading broker for interest rate swaps – let Citadel Securities into its dealer-only pool of liquidity, marking the first time a non-dealer traded swaps in such a manner.
Incumbent platforms such as Bloomberg and Tradeweb sprinted out to early leads in market share, dominating in both credit and rates.
Both firms, however, were plagued by allegations of non-compliance with a CFTC requirement that they provide impartial access to participants. Each denied the claims.
The remaining trio of start-ups struggled to gain traction and were tabbed as most likely to file a make-or-break MAT application. Javelin and trueEx continued to push for anonymous trading between buy and sell-side on an equities-like central limit order book, a proposition that has irked dealers keen to maintain the profits associated with the RFQ process. TeraExchange, meanwhile, focused its attention on developing the first regulated Bitcoin derivatives market.
GFI Group, one of the five major inter-dealer brokers in the space, tried to delist its wholesale brokerage business through the sale and repurchase to the CME Group over the summer, but had the transaction scuttled by a hostile and stronger bid from long-time competitor BGC Partners.
As the year came to a close, market participants looked ahead to 2015 with expectations that long-awaited consolidation would finally become a reality. And with the majority of the US$691trn OTC derivatives notional expected to eventually find its way on to SEFs. There was still everything to play for.
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