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The introduction of SEFs has brought both benefits and higher costs from fragmentation, warns OpenLink

Like opening Pandora’s box, the emergence of swap execution facilities in US derivatives markets has brought unexpected consequences and problems as well as benefits. In some cases, asset managers are actively looking to avoid trading on the new platforms and even turning to other asset classes, according to a new report by OpenLink.

Swap execution facilities emerged as a new kind of US trading platform in the aftermath of the 2009 G20 agreement in Pittsburgh, which sought to reform and regulate OTC derivatives markets by mandating reporting to trade repositories and central clearing on CCPs and pushing trades onto regulated platforms wherever possible. Although the purpose of SEFs was to improve transparency and reduce the size of opaque OTC markets, research suggests that the fragmentation of the market into multiple SEFs has created costs and inefficiencies that are impacting the ability of asset managers to trade.

“When we went out into the market asking questions, we found that there was an ideal of what participants wanted – and then there were regulatory and technological hurdles, market structure issues, clearing houses and the nature of SEFs themselves, that prevented that vision,” Phil Wang, senior analyst at OpenLink told Banking Technology.

The report focuses on five areas where users of SEFs will face problems. The first is bunched and blocked order workflows. According to Wang, the allocation process is problematic. If a SEF uses an RFQ model where the user has to make allocations pre-trade, that introduces challenges because further decisions may depend on whether or not trades are successfully executed. But the timeframe between execution and clearing does not necessarily give enough time to the asset manager to keep track of their liquidity, margin and credit availability across multiple SEFs.

Lack of visibility into credit and the true execution cost of an order impacts decision making by traders. In addition, some asset managers change the terms of the deal so that it doesn’t need to be executed on a SEF, and use more traditional ways of executing the trade that don’t involve a SEF.

“While SEF trading volumes have gone up, if you look at values, larger trades are still not being executed on SEFs – they are still being executed by voice,” said Wang. “It’s the smaller trades that are being executed on the SEF.”

The fragmentation of the market between multiple SEFs is also a major issue highlighted in the report. With liquidity spread across different SEFs, the liquidity in each is fragmented. Furthermore, while it was hoped initially that the new trading environment might help to lower costs for end investors by improving transparency, the reality according to Wang is that connecting to each SEF is an expensive business. Joining a SEF requires time-consuming legal agreements and audit agreements. If there are a dozen venues for rates products, most participants will only pick two, or at most three, that they wish to trade on. This undermines the ability of participants to gain the full benefits of competition.

Once there is a consolidation between SEFs and all the liquidity focuses on those few, then there may be enough liquidity and transparency to drive spreads lower and create better pricing for participants, but it will take time. Another issue is that users trading on multiple SEFs, the information isn’t instantly transmitted between all the SEFs how much the user is reserving, so users tend to go ‘ultra-conservative’, which results in less credit availability for other participants. This inefficiency ties up resources and increases costs. Furthermore, none of the SEFs will know the net position that a participant has. At the clearing house, there is no view of whether a trade reduces overall risk. The same applies to initial margin. Lower availability makes credit more expensive – undermining the efficiency of the whole process.

Asset managers are typically looking to execute a package of swaps and other derivatives to achieve an objective, usually rebalancing a portfolio. The net risk of such a move may not necessarily be very high. Whereas before the development of SEFs, institutions on the buy-side could generally count on their broker pricing such a group of trades based on the full net risk of a block, now that trading on SEFs is mandatory, each individual trade needs to have margin allocated against it – resulting in higher cost and margin payments than would have been the case if the whole trade were considered as a whole.

While CFTC Regulation 1.73 requires that a clearing member must credit check each transaction to ensure it will clear, credit checks are also typically done on the individual risk of each deal to see if it will pass or fail, and not necessarily incorporate the net position. Wang points out that where the effect was to reduce risk, this is overlooked in the process. The end effect, he says, has been a more conservative approach, which over-consumes credit lines and margins.

The difficulty of doing effective transaction cost analysis on SEF transactions can also make it difficult for investors to understand the full cost of a trade or series of trades. Previously, market participants would generally know the spread they received and therefore understand the major part of the cost associated with a transaction. But with trading on SEFs, the price being offered for a swap is only part of the bigger picture. There are also initial margin costs and clearing fees that need to be considered. These depend not just on the broker but also on the clearing house. Clearing brokers will charge a carry cost on the initial margin. According to Wang, participants do not necessarily have the tools to get clear visibility of the full cost and capital required for every trade. “There is a need for pre-trade analytics, and OpenLink is working on this,” he said.

Given all these constraints, the buy-side is increasingly looking at other alternatives. Some participants have received regulatory relief, meaning that they don’t have to execute package trades on SEFs. This kind of relief is termed a ‘no-action release’. Such exemptions are granted on the assumption that there is an expiration date after which it will no longer apply however, so continued exemption depends entirely on the good grace of the US regulator.

“Swaps require a lot more collateral and margin, and the cost of doing a cleared swap has gone up dramatically,” said Wang. “That makes them look at other kinds of product – such as swap futures or interest rate futures. Some product evolution is happening as exchanges introduce hybrid instruments to capitalise on that. It’s shifting the types of products people are looking at.”