When the U.S. Commodity Futures Trading Commission rolled out the rules for swaps execution facilities, it created a fragmented market structure in which buyside traders could access market liquidity directly, without routing orders through a futures contract merchant by becoming a member of an individual SEF.
It also created a regulatory headache for buyside firms in the process: To access all of the available liquidity of those swaps that are mandated to trade on SEFs, buysiders would need to be a member of each SEF that supports trading of the particular swap contract in question. If that weren’t enough, buysiders also had to decide whether a particular SEFs liquidity was worth the associated regulatory overhead that comes with membership in that SEF.
To sign all of the rule books and become a member of the 24 SEFs that are temporarily registered or pending temporary registration in the U.S., a firms legal team would need to scour more than 1,750 pages of SEF rules. Clear Markets North America, which is pending temporary registration at press time, has the shortest rule book, with 44 pages, while temporarily registered trueEXs rule book clocks in at 100 pages.
“By signing an SEFs rule book, the participant agrees that they would behave on the SEF marketplace according to the SEFs rules and agree to some level of oversight by the SEF, explained Jon Williams, head of U.S. institutional market operations at Tradeweb. The SEFs are responsible for making sure that their participants can operate in a regulatory compliant environment.
Joining an SEF also brings asset managers under the purview of some CFTC regulations that, up until now, had concerned only FCMs. One such example is Regulation 1.35(a), which states that each SEF member shall keep full, complete, and systematic records, which include all pertinent data and memoranda, of all transactions. These records would include all oral and written communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading, and prices that lead to the execution of a transaction in a commodity interest and related cash or forward transactions, whether communicated by telephone, voicemail, facsimile, instant messaging, chat rooms, electronic mail, mobile device, or other digital or electronic media.
While there was caution in signing rule books, there was not an overwhelming angst in doing so, as we have signed up more than 350 participants to our SEFs, said Tradewebs Williams. The angst really arose over the uncertainty of the scope of SEF jurisdictions over their members and its definition of participants on a platform.
It is not surprising that asset managers like global asset manager Babson Capital Management planned only five or six SEFs prior to the Feb. 15, 2014 made available to trade, or MAT, deadline, which mandated that certain swaps contracts could only be traded electronically on SEFs of designated contract markets.
We want to be as narrow to start, said Amy Caruso, director, program manager of Babson Capitals derivative initiative during a panel discussion at the Tabb Groups January Fixed Income 2014: Breaking Rates conference in Manhattan. We want to make sure we have all the pipes for vanilla on- and off-the-run interest rates properly in place.
To soften some of the regulatory, on Dec. 20, 2013, CFTC staff issued a time-limited no-action letter that provides relief for Regulations 1.35(a)s oral recording requirements for certain SEF members until May 1, 2014, at the behest of the Securities Industry and Financial Markets Association.
Even with the regulatory reprieve, SEF operators saw trading volumes on their platforms temporarily recede after the initial MAT deadline.
You could see people took a step back to make sure things worked and now we are seeing the volume ramp up quite nicely, said Ben Macdonald, head of product and president of Bloomberg SEF.
Futures Markets to the Rescue
To ease the buysides burden of accessing liquidity, SEF operators Bloomberg and Tradeweb introduced flavors of sponsored access to their respective platforms, in which asset managers and other buyside market participants could route orders to an SEF via an existing relationship with an SEF member.
“Offering sponsored access on the SEF is a logical progression when you look at some of the trading methods used by the futures markets, explained Bloombergs Macdonald. It is not surprising that you would see similar methods in the SEF space. It reduces the overall overhead of the end client, related to SEF and clearinghouse agreements and other things.
By adding such an offering, FCMs could foster stronger relationships between their clients and themselves, he added.
St. Louis-based NISA Investment Advisors was the first publicly identified asset manager to execute an order on the Bloomberg SEF via its relationship with Credit Suisse Securities in which Goldman Sachs took the other side, Bloomberg officials announced on Feb. 12.
It was also the same day that competing SEF operator Tradeweb saw its first on behalf of order executed on its TW SEF.
An OBO order is a subset of direct market access in which the non-SEF member designates an employee of another organization, typically the FCM, to act on their behalf and decide when and at what price to execute the order, explained Tradewebs Williams.
Tradeweb is also working with a number of independent software vendors (ISVs) to provide sponsored access capability to the buyside through embedded SEF GUIs or front-end trading portals provided by the ISVs and/or introducing agents, according to Tradeweb officials.
With SEFs adding these features to their menu of offerings, firms that are not compliant currently and do not have time to become fully compliant in time can fulfill their Dodd-Frank pre-trade transparency requirements with the aid of FCMs that acts as their agents, added Will Rhode, principal and director of fixed income at industry analysis firm Tabb Group.
Tradeweb Williams is adamant that such direct-market-access offerings are not being offered as a way to get around regulatory responsibilities laid down by the CTFC, such as Regulation 1.35(a). Market participants are acting in a regulatory compliant manner, and simply want to make sure they are meeting their fiduciary obligations to their ultimate end customers, which is becoming a much more complex endeavor, he said.
Overall, the new offerings are not pushing an envelope like opening a previously closed market line the inter-dealer broker community to the buy side would, said Rhode. These have more of a compliance focus to them.
Bloombergs Macdonald agrees that these DMA offerings are relatively small incremental changes to the swaps-trading market structure. There will be some tweaks to the model as we learn more, since this is fairly new territory, he added.
Nascent Adoption
Since Bloomberg and Tradeweb rolled out their respective sponsored access capability, their use has been much more the exception than the rule, according to officials from the SEFs.
We are seeing sponsored-access trades happening every week on our SEF, but it is still a small amount compared to standard executions, said Tradewebs Williams. But, for a handful of customers, they have benefitted from access to liquidity on SEFs through more than one approach.
According to Williams, six FCMs that are TW SEF members are supporting sonsored access capability to approximately 35 of their clients currently.
Bloombergs Macdonald also sees a relatively light adoption of sponsored access on Bloomberg SEF as the vast majority of the 600 firms, which currently trade across all the assets offered on the SEF, still are trading in their own names.
This is going to be an evolving story over the next three to six months as the market becomes more comfortable with the technology, he added. The last thing we want to do is predict how the landscape will look in three, six or 12 months. However, sponsored access will likely have increasing importance moving forward.
Neither is Tradewebs Williams worried about future uptake of the service, since only about 25 percent of the current customer-to-dealer swaps market is traded electronically, he said. Initially, the CFTC has certified only the most vanilla instruments as made available to trade on SEFs, and they provided no-action relief for package or multi-leg transactions until May 15.
This is going to be an evolving story over the next three to six months as the market becomes more comfortable with the technology, added Macdonald.
