I was originally going to start this column with the words ‘it feels like we’ve been talking about derivatives reform for years’, until I realized that’s exactly what we’ve been doing. There’s a sense of forward motion now, at least, with the first trades being reported to swap data repositories (SDPs) at the very end of last year, and large sell-side entities provisionally registering as swap dealers. Coupled with that was a recent trade by Citadel, using Bloomberg’s fixed income trading platform and brokered by Deutsche Bank, that closely mirrored how over-the-counter (OTC), or formerly OTC, will work under the new regime.
The devil is in the details now, which are focusing around connectivity, instrument transmogrification through the futurization of swaps, and the more technical aspects of how swap execution facilities (SEFs) will interoperate with the rest of the market infrastructure. Although the US Commodity Futures Trading Commission (CFTC) hasn't opened up registration for SEFs yet, many have declared their intent to do so, and are either building out or have built out their offering. But joining to these for trades can present a sticky problem for the sell side.
Obviously, all but the most advanced buy-side shops won't be interested in direct connectivity to SEFs. It's expensive, it'll require a lot of technology work, and there's no guarantee that the SEF will be there in a year's time. Instead, most people I speak to say that the connections will be offered as part of a premium vehicle to the buy side─by banks in their prime brokerage business or services segments, or by brokerages themselves, as part of the usual package. The aforementioned Bloomberg-Citadel-Deutsche transaction saw the latter as the executing broker, for instance, with the swap clearing through LCH.Clearnet.
Do you only connect to the largest, and therefore the most likely to survive through diversification, and risk not being able to provide for a client who wants to trade a particularly niche or exotic swap that still falls under the regulatory purview?
But there are a great many firms looking to set up as SEFs, so what do you do? Do you only connect to the largest, and therefore the most likely to survive through diversification, and risk not being able to provide for a client who wants to trade a particularly niche or exotic swap that still falls under the regulatory purview? That seems the most sensible, but it's not going to be cheap. Efforts are underway to standardize connectivity to SEFs, such as those by the Fixed Income Connectivity Working Group (FICWG), but they're as yet unproven.
As SEFs close either through attempting to draw liquidity through a limited pond, by operating costs and not achieving critical mass, or through consolidation, too, decommissioning and re-commissioning these connections may prove to be a sting to the wallet.
As with most things in life, it seems to be about organization. Having a plan in place, most argue, rather than reacting to landscape developments, is the most sensible course of action. While the exchanges are cornering the clearing market, it's the pipes that remain the purview of the sell side through the new era of OTC.
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