On May 16, 2013, the Commodity Futures Trading Commission (CFTC) approved four rules and issued guidance that would effectively move bilaterally traded swaps onto electronic execution platforms. In essence, the rules create the standards for interested parties to register and operate a Swap Execution Facility (SEF), and require that all cleared swaps trade on SEFs or Designated Contract Markets (DCM). The new rules necessitate a review of the existing operating model for all market participants. Swap dealers need to evolve their services to protect their market share while interdealer brokers have to consider new alliances to facilitate liquidity discovery through a hybrid voice and electronic trading service. Investors on the other hand, are monitoring the impact on transaction costs during liquidity discovery in conjunction with the costs related to spreads, collateral transformation and access to capital.
The most recent set of rules issued by the CFTC reduce the Request For Quote (RFQ) requirement from the original five participants to two in the first year, and then three participants in the second year. In addition, the Commission has allowed voice trading, which effectively permits interdealer brokers to maintain their current business model. Swap dealers must address these new challenges to protect their franchise, remain relevant, and increase their influence during the evolution of the new market structure.
A key consideration is the ability to provide a hybrid voice and electronic trading service coupled with capital commitment and liquidity discovery. These services will help continue the inflow of deals from their clients and enable dealers to participate in the more lucrative, large, non-standard transactions. The new environment also creates the need to address the orders, risk controls, client credit limits, and pre-trade decision support to respond to the electronic RFQ’s 15 second response limit. The 15 second limit would also warrant a closer look for possible protection against predatory trading.
An emerging product consideration is the ‘futurization’ of swaps (futures contracts offering swap like protection) that is driven by the simple and well understood nature of futures trading and margin requirements. The ownership limitation on SEFs along with the futurization of swaps creates an interesting challenge for brokers as they are forced to form alliances and provide access to other venues in search for liquidity.
The fragmentation of liquidity introduces an added layer of complexity to both the front office and operations, as pre-trade analytics, risk, trade management processes and controls must be reviewed and adjusted, internally. IT organizations are reviewing the new requirements and prioritizing the work necessary to enable new trading capabilities while keeping a close eye on controlling the market and counterparty risk. They must now address areas that will require new functionality or extensions to existing functionality such as: