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THE STATE OF THE SEF MARKET

DESTINATION UNKNOWN

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SEF MARKET – DESTINATION UNKNOWN 3AUGUST 2014

CONTENTSINTERVIEW: SCOTT O’MALIA, COMMISSIONER, CFTC When Scott O’Malia approved the final swap execution facility (SEF) rules in August 2013, he did so “reluctantly”. His fears were realized when the regime quickly wrought international havoc. In one of his last interviews before leaving the US Commodity Futures Trading Commission (CFTC), he relives the ordeal of bringing these rules to market and highlights many of the challenges still to come.

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SEF SURVEY RESULTS: FX MARKET SEFs STRUGGLE TO GAIN TRACTION WITH CLIENTS16

SEF SURVEY RESULTS: IRS MARKET INTERNATIONAL PLAYERS SLOW TO ADAPT18

MARKET FOCUS: FROM CONFUSION TO CONSOLIDATIONSwap execution facilities were supposed to bring transparency and price certainty for the whole market. Instead, though, they have forced traders back onto the phones and fragmented liquidity internationally. But whether markets like it or not, the changes are here to stay, so how best to adapt?

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Production manager: Daniel PalmerEditor: Catherine SnowdonPublisher: Timothy Moxon

SEF MARKET – DESTINATION UNKNOWN4 AUGUST 2014

In this report, Euromoney Research Group sheds light on the trials and tribulations of the introduction of swap execution facility (SEF) rules in the US and its effects globally.

After the shock of rapid and sweeping structural market changes, we talk to one of the regulators instrumental in establishing them. US regulators are now working out the kinks in the legislation and hopes are high for continued adoption of this way of trading.

To ascertain the remaining challenges, we surveyed FX and IRS market participants, including buy-side firms such as hedge funds, banks, corporates and insurance companies all around the world. ERG also spoke to the majority of market-leading SEFs to get their views on where this market is going.

Issues covered in this report include the continuing global regulatory work, as countries

attempt to comply with the principles agreed at the G20 Pittsburgh summit in 2009. We ask whether enough cooperation is happening among regulators and what can be done to speed up the process. We uncover the barriers to trading on SEFs and what market participants say will encourage them to transition to this way of doing business.

Throughout the process we found market participants to be open and honest about the difficulties faced and those that lie ahead. Underneath it all, however, was a confidence that everyone will benefit from the increased transparency that is at the heart of introducing SEFs.

Catherine SnowdonEditor, Euromoney Research Group

EUROMONEY RESEARCH GROUP THE STATE OF THE SEF MARKET – DESTINATION UNKNOWN

INTERVIEW


Euromoney: Are you happy with how the introduction of the SEF regulations has gone so far? O’Malia: I am very optimistic about swap execution facilities (SEFs). We were able to create an environment that was flexible, that would give everybody the opportunity to find the best way to transact their products and recognize the differences between the swaps and futures markets.

There are large notional size trades, but relatively few of them. So we’ve shown that people can transact through an electronic platform so we get the transparency that suits the market and our regulatory purpose. Now we are trying to figure out the best way to really move this forward.

In credit default swaps you’ve got tremendous uptake on screen, but these are more standard products of course. Dollar-denominated interest rate swaps are seeing more volume than non-dollar-denominated. Our challenge is to bring more liquidity to the market and more buy-side participation.

Poor buy-side participation is eminently fixable. Any issues they have regarding SEF access, rule-book issues, how many SEFs they want to access, what products are being traded, where the liquidity is in these markets - those are the issues we want to attack.

What about broadening the range of products available on SEFs?We need to consider newer products, such as packaged trades. We have more and more of these going on-screen: let’s see if that helps increase participation.

We’ve spelled out a schedule for new products so people have some certainty. It’s important to phase these things according to the complexity and different features of each product.

For example, if the CFTC determines that non-deliverable forwards (NDF) are suitable for

clearing, the next step will be to determine the process for making them available to trade.

When it comes to NDFs, I’ve heard concerns about integration, physical connection, transaction integration, clearing and exchange trading intermediation and so on. This is not the futures market. We need to understand if there are complications around the role of prime brokers, for example.

But as I understand it the NDF proposal is complete from a staff level and it is ready to go to the CFTC fairly soon.

How aware are you of the widespread confusion in the market when it comes to the SEF rules? I am very sympathetic to the marketplace and their level of confusion. We have gone through a three-year rule-making process in which we’ve done 68 final rules. We have rushed through these rules at record pace. I’ve never seen any other federal agency move this many rules this quickly. And as a result we’ve made some mistakes.

Our challenges manifest themselves in the data. We’ve had well over 190 staff no-action letters [statements overriding or changing specific parts of the final rules]. We’ve issued temporary relief, permanent relief and every variety thereof, all trying to accommodate the rules.

I’m supportive of the no-action relief obviously because we have to offset the rush that we did the rules in and the complications that we’ve created as a result.

My frustration is when you look at the entire way we’ve gone about this. Going so quickly we haven’t asked the right questions. We didn’t expect many of these outcomes and as a result we’re actually backtracking through the no-action relief to try to accommodate technological policy changes that the market is not ready for.

What are you doing to address the issue?Early on I have been consistently asking for a schedule, what rules we are going to do and when, so people can get their minds around the rule order and the phase-in of the implementation dates.

The market needs to know when they need to have connections, relationships and new paperwork in place to make sure they are able to trade and clear all of these products as expected. And report data too, which is important.

We also need to consult the market and ask what is possible. The schedule is a problem and it’s been a consistent problem for the past three years.

What sort of response do you get from the market when you ask questions?The market has had a very steep learning curve. Early on there was a little bit of denial about the expectation of how far we would get and how quickly we would get there.

But everybody now completely understands what the rule set looks like.

They are anticipating and helping us understand how the infrastructure, the SEFs, the clearing houses and the data reporting will function and does function and what can be done in what period of time. That’s very positive.

INTERVIEW: SCOTT O’MALIA, COMMISSIONER, CFTC

When Scott O’Malia approved the final swap execution facility (SEF) rules in August 2013, he did so “reluctantly”. His fears were realized when the regime quickly wrought international havoc. In one of his last interviews before leaving the US Commodity Futures Trading Commission (CFTC), he relives the ordeal of bringing these rules to market and highlights many of the challenges still to come.

“I am very sympathetic to the marketplace and their level of confusion”

INTERVIEW


What happened to make market consultation ineffective before the rules were released?People got confused by the lack of specificity in our questions. We weren’t able to pull the right information out as a result and the industry was left guessing what we wanted. So there has been miscommunication and false expectations about what these rules were going to be.

Footnote 88 had wide implications. Were the effects intended?This is where our cross-border rules over-reached. We were trying to guess at some of these things and what the ramifications would be. When we read the statute we knew we were well beyond our ability to enforce it. The statute essentially says we can apply our rules extraterritorially to the extent it has a direct and significant impact on our economy.

So you have to ask yourself, what is a direct and significant impact? We never received a satisfactory answer as to how a US person involved in exchange trading outside the US would bring risk to our shores, especially if the trade is cleared.

We just applied the rules broadly and as a result we over-reached. We hurt relationships internationally by expecting to apply our rules in foreign jurisdictions.

Instead we should work with colleagues internationally to make sure we have the comparable rules that we can all rely on. Share the data and have the confidence that each other’s clearing houses are robust and completely in line with international standards.

Then with execution we can work out deals to make sure we have that comparability so you don’t create an arbitrage opportunity that would excuse people to trade somewhere else and undermine our rules. But at the same time we don’t police the world, so we have to do this in a cooperative fashion.

Do you remember how long you had to read over the rules before they became final?We negotiated them for over a year. But footnote 88 came in at the very last minute. It was not in the draft proposal that the market saw. It came into the final draft; the market didn’t see this thing coming.

Europe didn’t have any reason to fear a SEF rule that was to be applied domestically but then all of a sudden it applied everywhere. And you begin to understand, this is crazy. Traders in Europe, trading and clearing there but with either a lawyer or some expert here, and all of a

sudden it’s a US trade. It doesn’t make sense.There is a lot of energy spent trying to

understand and comply with the rules when, had we made them with a more international mindset, we could have saved everybody a lot of time and energy.

Turning to international cooperation, is enough discussion happening between regulatory bodies around the world?From the beginning we’ve had good relationships and good intentions among all the regulatory entities. There are some differences in the rule sets and there are certainly timing differences, which bring certain challenges.

Asia is not as keen on exchange trading and we have some clearing and trading timetable differences with Europe.

Data is a great test case. Everybody fundamentally agrees on the objective and we are all in a process of implementing swap data repositories.

Now we have to solve the really difficult challenge of harmonizing the data. We need to unify, as regulators, that form and format the data should come in, so we can begin to share it and do broader market analysis.

We need agreements to be able to share the data. Because as appropriate from time to time we will need to share information about certain market participants. Or simply compare notes about where there is risk build-up.

We’ve made some headway. We have the facilities in place and we have reporting. The US has had reporting for over a year, Europe wasn’t far behind, but we need to take the next steps and we need to do so immediately.

This is a difficult situation to manage. Data is complex and it requires very specific outcomes

Scott O’Malia CFTC Commissioner

Footnote 88 says that “a facility would be required to register as a SEF if it operates in a manner that meets the SEF definition even though it only executes or trades swaps that are not subject to the trade execution mandate”. ✪ This changed everything✪ Brought many more products into SEF realm✪ Rules applied to trades with all “US persons”✪ If a US entity was involved somewhere in the trade, the rules applied✪ Caused shockwaves around the world

Footnote 88:

INTERVIEW


and inputs and we need to make sure that we understand what those are so we get good-quality data.

Right now I would characterize our data quality as poor. There are inconsistencies coming in in terms of how people report and we have four different data architectures that make our job more complex.

What about when it comes to clearing?We have clearing houses internationally; we know the standards and we understand what the risk management and oversight responsibilities look like. We’ve been doing it for years. It’s important we get international recognition sooner rather than later for one another’s jurisdictions because we’ve all agreed to the Principles for Financial Market Infrastructure.

If we don’t recognize global clearing structures we will fracture liquidity and that could be intractable for a while, which wouldn’t be good for anybody.

I’ve sent a letter to commissioner [Michel] Barnier [European commissioner for internal market and services] making sure we stay focused on these issues and I know they are supportive of these goals. But at the same time we actually have to recognize one another’s jurisdiction and the entities within it.

We are never going to get to a rule-by-rule analysis. It’s an outcomes-based objective; we have to be flexible to some extent so we can continue to recognize one another’s rules even though they don’t exactly match up.

If we try to make them exactly match up we will not succeed. There has to be a dialogue which is a little bit more aggressive in terms of getting to outcomes by the end of the year to achieve them.

That’s the set timeframe?My understanding is that December 15 is a hard deadline for European clearing houses to comply [with European regulations] and the market needs that certainty. They need to know the schedule and which clearing houses Europeans will be able to transact with.

They need to be able to make the decisions and, if it comes with conditions, what they are. And how difficult they will be to comply within the timeframe.

Do you get a good response when you engage in conversations with your regulatory counterparts around the world?Absolutely. The US in my opinion had a broad overreach of our cross-border rules and that

hurt negotiations going forward. It damaged the relationships in some respects.

We are doing a good job of healing those,. but we have to demonstrate that by action not just by words. The easiest and best first step would be on data. Let’s get to a recognition on data harmonization.

We’ve taken some difficult steps and not necessarily successful ones on trading. We have the most time on trading; Europe’s trading mandate isn’t until 2016. We now know what their rules, by and large, look like for multilateral trading facilities [the European equivalent of SEFs]. Having discussions now about timing and structural differences between the regimes will bring about better regulatory harmony when the trading mandate in Europe occurs.

We’ve sent enough letters back and forth. Now it’s time to sit down, put our lists on the table and work out how to solve our differences.

Asia seems a long way behind in terms of adopting similar rules. Does that worry you?I’m not so worried about it because speaking with the regulators throughout Asia, they are committed to this effort. Liquidity in those markets is less and the size of the markets is smaller but I don’t have a sense that they are any less committed to making the necessary reforms. We’re going to have to adjust for time but I don’t sense any lower dedication to the end goals.

What about the idea of a universal rule book for SEFs? Could that work?No, it’s not possible. This is a principles-based system of outcomes, we are never going to be identical. It’s about accepting the differences and how you are going to solve those.

There are questions about the consistency of data being reported in the SEF market. Do you regret not being prescriptive enough in the rules?With regard to data you have to be very specific about what you want. We have questioned the market about how to improve our data rules. We need to eliminate the inconsistencies between the various rules to improve data quality and reporting.

We don’t want a rule set where there are various possible outcomes. To provide that certainty will improve the quality of the data and allow us to get what we want out of it.

We went into this asking for everything and not knowing how we would use it or for what purpose. I’ve challenged our staff and the CFTC to think about our priorities in data and technology. Now that we see how big a challenge the data is, we are not going to be able to do everything immediately.

What’s your top priority?I would put risk management at the top of the list. Understanding bilateral risk management or knowing in which asset class we are seeing a big build-up of risk. The London Whale was a good reminder that these things can happen. We need to have very clear insight into what’s in the clearing house and what’s outside it and know where risk is building.

It’s a very exciting opportunity; we now have all of this data for the first time. We are looking at how to use it to best effect.

You are forward-thinking when it comes to the use of technology. What is your focus? Data integration is key. You can’t develop the full picture without pulling all the pieces together.

We’re looking at what it means to have complete surveillance of our markets and how to do comparative analysis between financial products. You have to always be thinking about cross-market trades as well. Working with Finra [the US Financial Industry Regulatory Authority] and the SEC, we need to think about what the next generation of data surveillance looks like.

I’ve been advocating for a strategic plan largely because we need to put on paper our priorities based on our mission and needs. We need to understand what we need in terms of hardware, software and personnel expertise.

We need more data scientists – people who can work with the data effectively, who can programme and develop automated surveillance tools. The massive amount of data

“The US in my opinion had a broad overreach of our cross-border rules”

“Right now I would characterize our data quality as poor”

INTERVIEW


that we take in is not something we can throw people at; this has to be an automated process.

After all, you are taking on an automated market.Exactly. They are trading in a 21st-century way, we are surveilling it in – in my opinion – a very 20th-century way. And that’s just not going to be a successful endeavour in the long term. We need to adjust to the realities of the way the market trades.

We need to bring in order data, something I’ve been asking for and something we’ve provided absolutely zero funding for this year. In automated trade tools, the behaviour and how they trade is in the order data, not necessarily in the transaction data, which is almost stale.

Expanding the types of data we collect will be a learning experience; it’s not something we’ll be able to quickly intake. It’s a massive amount of data, physically. And then to do the analysis, it’s a huge task. But we need experience with that now, so we can be effective in the future.

I’d like to see a bottom-up approach, have the divisions in this building tell us what they believe their priorities should be and then the CFTC can take all the different priorities and knit it together for a full strategic plan. It has to be a one-year and a five-year vision, because this isn’t going to be done overnight. Waiting for this strategic plan is painful and it’s long overdue.

Statutorily we were required to implement a strategic plan one year after the president’s inauguration. We’re well past that date.

What’s causing the delay?A lack of focus on the specifics. We haven’t focused intensely enough on our priorities and the specific technology and mission functions that we want to achieve. Those are hard decisions to make but there hasn’t been enough attention paid to it and therefore we don’t have any results to show for it. I keep talking about it, raising the pressure and the issue to hopefully create some sort of catalyst in order to get this done.

Do you have a technology team, with data analysts already?We do, but we don’t have nearly enough. We have different skill sets, some are very good with programming, some with market surveillance, but there is a lot more that needs to be done. It will be dictated of course by the mission we take on. If we are going to expand, for example, our risk analysis, that’s a different skill set we need.

Do you have enough staff with the right market experience to oversee this complex market?As a result of the rule-making we have really enhanced our market knowledge. This is a market that was outside of our jurisdiction, so there shouldn’t have been an expectation that we knew everything about it. But it is now completely within our jurisdiction and we are building a lot of knowledge and experience.

Our learning curve has been steep but we have tackled it very well. I am impressed with the enormous amount of hard work, time and energy that has gone into this. The staff have learned fast and tried to write rules that accommodate the nuances and unique characteristics of the swaps market.

By and large we got them right, but we made some errors. Now we are in the implementation-correction phase. If we stopped doing the corrections and said “we got it right” that’s when we’d have problems. We are willing to consider changes and that is healthy and appropriate.

What about start-up SEFs struggling with poor volumes and slow uptake? Do you expect to see consolidation?I appreciate that the willingness to invest in these and try new technologies and innovations takes great commercial spirit. And I know that of the 20-plus SEFs that have come in for registration not all will survive.

But I like the different ideas that people are coming up with and the different products coming out. Innovation is going to be a great thing for this market and it will create new opportunities.

I can’t predict where this will end up, but

we are looking at ways to get more trading done on-SEF and allowing people to transact in the way they want to.

SEFs are going to continue to evolve and I don’t want us to insist on a single solution; we need to learn from the equities market in terms of fragmentation and what can happen there. This is a new market and we need to stay flexible and think innovatively, just like the market participants are.

What has been the biggest challenge in your term?It’s difficult when you are presented with what is deemed a consensus document led by the chairman and supported by the staff and told: “Here it is, take it or leave it”.

The hard work has been to try to forecast what could and might go wrong and to do my own independent research and analysis into how the market might not function as well as expected under this rule.

That requires a lot more work on our side. My staff have had to work very hard to think critically and anticipate something other than what is being sold to us.

Are you likely to seek another term?[With a wry smile] I do love this job. I’ve had a lot of experience on Capitol Hill, developing rules and statutes and I thought that was a terrific job. But to have the opportunity to be on the receiving end of the statute and be asked to get the details right is different. And the details clearly matter, so to take it to the next level in terms of policy analysis is fascinating to me. I’ve enjoyed all of my policy jobs here in Washington but this one is special. The stakes are very high and the outcomes are important.

[Since talking to Euromoney, O’Malia has formally resigned from his post at the CFTC. He will take up the position of chief executive of the International Swaps and Derivatives Association on August 18.]

This article was first published on August 8

“I know that of the 20-plus SEFs that have come in for registration not all will survive”

“We need to bring in order data, something I’ve been asking for and something we’ve provided absolutely zero funding for this year”

MARKET FOCUS


The introduction of the US swap execution facility (SEF) rules has caused problems, globally. Markets have battled to adjust to this new way of trading and the fight, for many, is not over.

The concept underlying the rules was straightforward: at their September 2009 summit in Pittsburgh, G20 leaders agreed that by the end of 2012 “at the latest”, all standardized over-the-counter (OTC) derivatives should be traded on exchanges or electronic trading platforms “where appropriate”. The International Organization of Securities Commissions (IOSCO) was involved from the start, setting out detailed principles for securities regulation. Although no G20 member met the 2012 deadline, the US has taken substantial steps towards full implementation.

On July 21 2010, president Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The legislation tasked the US Commodity Futures Trading Commission (CFTC) with overseeing a large part of the US swaps market.

The final rules were ready by August 2013 and set out their goals:

“Title VII of the Dodd-Frank Act amended the CEA [the Commodity Exchange Act, which lays out the statutory framework under which the CFTC operates] to establish a comprehensive new regulatory framework for swaps and security-based swaps. A key goal of the Dodd-Frank Act is to bring greater pre-trade and post-trade transparency to the swaps market… Such transparency lowers costs for investors, consumers, and businesses; lowers the risks of the swaps market to the economy; and enhances market integrity to protect market participants and the public.”

A level playing field for market participants with better transparency and lower risk prompts no complaints. The rules and guidance that came with them defined the type of trading platforms required to register as SEFs, the core principles by which they must operate and the execution methods to be used. Simple? Or not?

When research on this market is undertaken, the word most commonly used by market participants to describe the rules is “confusing”. The task of deciding how and when to phase in these regulations and who would decide which asset classes and instruments they would apply to must have been daunting. As outgoing CFTC commissioner Scott O’Malia acknowledges, mistakes were made along the way. But those closest to the market understand the difficulties involved and accept that the US moved quickly in an attempt to give markets certainty as soon as possible.

“The EU is following a principles-based approach and is taking longer to come up with the regulations,” says Paul Millward, product manager FX at GFI Group (a SEF). “In the US

the rules were finalized much more quickly. They are clear and well defined although of course there are still issues that need to be worked through.”

Scott Fitzpatrick, chief executive of Tradition SEF, says: “The CFTC came out of the gates very quickly, and were very aggressive with their timelines for implementation. To an extent I respect that they went first, someone had to. But I don’t think they spoke to enough people for long enough before they issued these rules.”

Some observers try to look for the positive

aspects of the US racing ahead in introducing regulation.

“In coming out with their rules so fast, the US is giving us empirical evidence of how markets and liquidity are affected by this type of regulation,” says Peter Best, chief operating officer at Icap SEF.

Unintended consequencesEven the most pragmatic of market participants were shocked by the way the rules were blasted out however. Last-minute changes had large, possibly unintended, consequences. The most prominent example of this is footnote 88.

The footnote says that “a facility would be required to register as a SEF if it operates in a manner that meets the SEF definition even though it only executes or trades swaps that are not subject to the trade execution mandate.”

This changed everything. Before this point, products would only have been required to trade on a SEF if they were subject to the mandate, which was only applicable to products that were required to clear. Add in that the rules applied to trades with all “US persons”. This meant that whether or not the person actually doing the trade was a US citizen, if a US entity was involved somewhere in the trade, the rules applied. This generated shockwaves around the world in the complex global markets.

Market participants describe being “flabbergasted” and “stunned” when they read the footnote.

“Prior to SEF rules being published, people expected the rules to be applied incrementally,” says Best. “Footnote 88 threw people off. It came as a shock to the industry and the logistics of delivering on these rules proved challenging.”

Fitzpatrick of Tradition SEF adds: “That footnote took this from being a relatively logical, narrow-scoped set of products that were going to be subject to mandatory clearing and everyone knew would ultimately be subject to mandatory trading, primarily in the US between

FROM CONFUSION TO CONSOLIDATION

Swap execution facilities were supposed to bring transparency and price certainty for the whole market. Instead, though, they have forced traders back onto the phones and fragmented liquidity internationally. But whether markets like it or not, the changes are here to stay, so how best to adapt? Euromoney Research Group investigates.

“I believe we’ll see a flight to quality, only the strongest SEFs will make it” Zohar Hod, SuperDerivatives

MARKET FOCUS


US participants, to instead affecting your entire global swaps business. It was incomprehensible. From being a US issue, this became a global implementation of CFTC rules. It was a completely unmanageable situation given the timelines that were being set out. There was certainly a moment in time where we were dealing with global chaos.”

George Harrington, global head of fixed income, currency and commodity at Bloomberg, says that although the situation is now improving, footnote 88 did not help proceedings. “The lack of clarity in the rule-making process has caused a level of uncertainty in the market,” he says. “Cross-border guidance has sometimes been conflicted and, as a result, many participants chose alternative execution methods to SEF trading.”

For the FX market, the shift caused by footnote 88 was particularly shocking as it meant market participants were drawn into the fray long before they expected to be.

“In terms of impact on the FX market it has meant lots of work for the venues, to be assessed to comply with and meet the SEF registration requirements,” says Best. “Platforms with an FX bias weren’t prepared for this.”

The footnote also had implications for the buy side.

“Non-deliverable forwards [NDFs – FX instruments traded on SEFs] were slowly becoming increasingly electronic before these rules,” says Michael O’Brien, director of global trading at Eaton Vance. Now, he adds, his firm is back to trading FX on the phone in order to side-step the SEF rules.

The slow adoption of trading on SEFs by the buy side is a worry for SEFs, particularly

the start-ups that need clients to make their investments worthwhile. For some, the negative reaction was expected.

“I think the buy-side response generally to this regulation, and to all regulation that I’ve ever seen in my career, is: ‘This doesn’t help me, it’s complicated and I didn’t ask for this.’ And that is what we are seeing.”, says Jodi Burns, head of regulation for marketplaces at Thomson Reuters. “I don’t think it should have been a surprise to anyone. I think you have to take a long view when it comes to assessing the benefits of regulation.”

For O’Brien the delayed uptake is more than justified. “We’re talking about a giant, rapidly changing market structure,” he says. “I know people have put money into SEFs and various different business models that rely on the buy side coming to the SEFs, but my concern is our fund’s shareholders, not whether someone’s business model is justified or not.”

Complex on-boardingThere are a few reasons for the slow uptake of on-SEF trading. A big one is the arduous process of on-boarding with each platform. Clients must agree to sign up to a rule book, which is different for each SEF they want to trade on, and can run into the tens or even hundreds of pages.

“From an asset-manager perspective we have to think about how this fits into our internal agreements and relationships with clients,” says O’Brien. “Can we sign up a client for this? One of the fears in the beginning, and no one talks about it anymore although I’m not sure it’s been addressed, is if I trade on a SEF for a client account, does that mean the SEF can go and audit the client’s books? Once you start to think through some of these things, it’s insane. SEFs will say they don’t plan to do that, that they have to have that language in the rule book by regulation, but that doesn’t mean I want to take that risk. I know a lot of buy-side firms have signed up for these rule books, I don’t know why.”

The process of on-boarding is also a big undertaking for the SEFs. Bloomberg has taken

a client-by-client approach.“We work with a wide spectrum of clients

that represent a number of different geographies and sizes,” says Bloomberg’s Harrington. “Our SEF has more than 800 global participants and more than $5 trillion has been executed (across credit, rates, FX and commodity derivatives) since our October launch. Each of these clients has specific needs, but our general approach is to understand these needs and how they can benefit from our SEF technology and experience.”

Once a client has signed up it must be aware that it is transacting in a constantly shifting landscape.

“Rule books across the SEF community are changing monthly for all sorts of good reasons, like expiry of CFTC no-action relief letters and so on,” says Fitzpatrick. No-action relief letters have been issued by the CFTC to relieve market participants from parts of the rules while regulatory kinks are sorted out. They are effectively temporary or sometimes permanent rule changes and all 190-plus of them must be reflected in the SEFs’ rule books.

“SEFs have to update their rule books as the CFTC provides further guidance on the rules,” says Grigorios Reppas, CDS product manager at MarketAxess. “In the beginning we were updating every week, now it’s about once every two months or so. But that could change again.”

Burns of Thomson Reuters, thinks a process of adjustment is needed. “The buy side is less used to being regulated; they don’t all have a compliance officer and an army of lawyers to help them figure out what the rules of conduct are,” she says. “The idea that they have to agree to abide by a rule book is a foreign concept to them. There is seemingly no upside to joining SEFs directly. It opens them up to compliance obligations they would rather not deal with; they just want to trade.”

Failure to convertThe objection to the strict compliance regulations also extends to platforms that had considered becoming SEFs. One international FX trading platform that ultimately decided not to make the move to become a SEF had estimated the costs of doing so as in the millions of dollars. “We’d need a new compliance and technology team dedicated to this facility, separate from the teams we already have in place for the rest of the business,” the head of the European arm of the platform tells Euromoney. “It didn’t make business sense for us,” he adds.

At a CFTC event in June, Wendy Yun, a managing director at Goldman Sachs Asset Management, stressed the importance of the

“I know a lot of buy-side firms have signed up for these rulebooks, I don’t know why” Michael O’Brien, Eaton Vance

MARKET FOCUS


over-arching impact of these regulations on the market. She said the costs relating to trading on SEFs, including when it comes to assessing rule books and developing technology, were big concerns.

At the same event, Lee Olesky, CEO and co-founder of Tradeweb, admitted that the integration process for each client was “massive”.

Burns at Thomson Reuters remains upbeat about the situation. “Uptake has been what I expected,” she says. “Given that no one was required to trade [FX] on SEFs the fact that any SEFs have customers is a good thing. The Thomson Reuters SEF has over 200 buy-side customers prior to the mandate. We’re pleased with that uptake, as well as our market share and the number of liquidity providers who have joined the SEF.

“We’re also pleased with the fact that some of our buy-side clients have joined the SEF despite the fact they aren’t subject to Dodd-Frank. They want to trade with counterparties who are [on the SEF], in order to continue to tap into all the liquidity pools that they had before there were SEFs. So they’ve joined the SEF voluntarily. To me that’s the biggest endorsement of SEFs and our platform.”

Bloomberg is also content with business. “We’ve been pleased with the level of participation and volumes executed on our SEF,” says Harrington.

Referring directly to the Thomson Reuters SEF, FXall, O’Brien explains why for him, the option to trade on a SEF is closed for now. “Because of footnote 88 and rule books being what they are I can’t trade FX on the SEFs,” he says. “FXall is a good example, I can’t use them because of the SEF rule, even though NDFs don’t have a mandate, I can’t use them. We’re back to trading on the phone.”

Asked if this back-tracking is problematic, O’Brien is nonchalant. “Electronic is a more convenient way to get competing quotes, but it’s not a big deal for us to be back on the phone,” he says.

Trading off-SEFFor those choosing not to trade on SEFs there are alternatives. One popular way for customers to access SEF liquidity pools without on-boarding with a SEF is to use an introducing broker, which is a term set out by the SEF rules.

A firm can become an independent software vendor, which means SEFs allow impartial access to their markets. However, once the code is designed and connected to the SEF, the provider is merely a front end for the data. To get to the next step and allow clients to trade electronically on the SEF, they must become an “introducing broker”. UBS has done that via a SEF aggregator on its NEO platform.

“Building the SEF aggregator was part of our response to help clients continue trading certain swaps post the Dodd-Frank legislation,” says Mark Russell, head of EMEA FRC execution services. “The main idea was to aggregate all of the SEF central limit order books into a single screen so our clients didn’t have to worry about choosing the right connection points to access the best liquidity. With our aggregator they have access to multiple SEFs in one place.”

There is increasing pressure on other banks to come up with similar offerings, and rumours are rife of joint ventures between hi-tech trading platforms and banks. Credit Suisse appears to have gone furthest in developing a SEF aggregator, with reports saying the bank will launch the facility in August 2014, although confirmation was not received from the bank at the time of going to press. Russell says he isn’t

worried about competitors: “We know others are building similar products, but competition is good. In some ways it justifies your decision to be the first mover.”

O’Brien uses the UBS aggregator and would like to see more options. “UBS is the only model right now that gets us where we want to be,” he says. “At this point it does surprise me that it is the only one. Given all the problems with the rule books and the complexity of the buy side getting onto the SEF, I would think more people would be doing it and I suspect they are, they just haven’t come to market yet.”

UBS is seeing uptake globally, but there is less demand outside the US in countries where traditional trading methods are still acceptable, beyond the reach of the Dodd-Frank Act. As the direct participant, UBS must sign the SEF’s rule book, something Russell is relaxed about.

“We are taking on this responsibility; it is part of the service to our clients,” he says. “There are some rules that apply to everybody, regardless of whether you are a participant or accessing as a client of our introducing broker service, and then there are some which apply only to the participants.”

Despite the bank signing the rule book, this does not mean clients that access the market this way are beyond the rules’ reach. “Customers of SEFs are all subject to the rules in some way, you can’t trade through an exchange or a SEF and not be subject to the jurisdiction of the SEF and therefore the rules,” says Fitzpatrick. “The onus of responsibility for the understanding and applicability of the rules sits ultimately with the entity transacting on the SEF.”

Reppas agrees: “At the end of the day, everyone is under the jurisdiction of these rules. You can find alternative ways to access the SEF without needing to sign up directly, such as using an introducing broker, but the rules still apply.”

Innovation is never lacking in the lucrative financial markets and there are other platforms that will allow easier access to SEF markets on the way. SuperDerivatives, a trading technology and analytics firm, has created SDeX, which is described as a “trade communication system”. It enables participants to price bespoke products across asset classes, none of which is currently mandated to be traded or centrally cleared. The firm has applied to register as a SEF to be certain it complies with US rules, but is determined not to call its platform a SEF.

For SEFs, the different models and the competition they generate is troublesome.

“I am happy to compete with other SEFs for their business; it’s competing with the alternatives to SEFs that is hard,” says Burns. “It’s not a fair

✪ Check for unique offerings✪ Do they cover the asset classes you want to trade?✪ Liquidity is crucial✪ Trading protocols – do they align with yours?✪ Read the rule book carefully✪ Question if you need to join – any alternatives available?✪ Don’t panic and on-board too quickly, it’s an expensive and time-consuming process (Summary of advice from SEFs spoken to by Euromoney)

Advice for newcomers to SEFs STUDY THE SEFs

MARKET FOCUS


playing field because those non-SEFs don’t have regulatory requirements, so I’m competing with an arm behind my back.”

Yet Burns understands why some potential clients might be reluctant to join a SEF when it comes to the FX market in any case. “Some global corporations are trading FX because they don’t have a choice,” she says. “They have global payroll obligations; they are collecting revenue where they are not headquartered and therefore need to repatriate that revenue back to their home currency. It’s just the cost of being in the business they are in. So they don’t understand why they have to go through all these hoops just to continue trading.”

However, the day is likely to come when they will have to. Trading mandates are expected to follow. Unfortunately the road from this point in the phasing in of SEF rules is far from clear. Timings for new rules are still uncertain and as the CFTC’s O’Malia admits, there is much work to be done to correct mistakes in the rules already implemented.

International wranglingOne hurdle to overcome is the apparent lack of cooperation with regulators around the world. A big concern for the market participants Euromoney spoke to concerned the clearing mandate for swaps, and how timing and coordination on this front would work.

“The CFTC has indicated it might introduce mandatory clearing rules by the end of this year,” says Best. “So now we are beginning to think about how we will accommodate execution-level requirements in a very real way. We have an electronic NDF platform, but we need to focus on how we get permission for access across other regulatory jurisdictions.”

Burns says of the clearing mandate: “This is still a work in progress. There are some very basic operational issues that have yet to be made crystal clear, which is an additional challenge for everyone who is involved in the clearing process. It is hard to build systems because you don’t really know what your requirements are.”

It is expected that in Europe the earliest that mandatory clearing will begin is the end of this year, and at the latest next summer. The deadlines are dependent on the European Market Infrastructure Regulation, under which clearing and the authorization of clearing houses are regulated.

Reppas thinks participants might already be testing their processes on SEFs. “We are now seeing a trend of European investors trading increasingly on the SEF,” he says. “The reason is that more and more clients are starting to clear their index positions. Here in Europe we will have the clearing mandate very soon, so these clients are preparing for that and the perfect venue for them to try these things is on the SEF.”

Unfortunately there is no sign of a real effort to ensure that the US and European rules work in harmony to allow efficient clearing of international trades.

Coordination between international regulators has been at times difficult. An example is the apparent collapse of the negotiations between the US and Europe over qualified multilateral trading facilities (MTFs), an agreement that could have allowed swaps traded on the European equivalent of SEFs to avoid much of the pain of the Dodd-Frank Act. Nevertheless the commitment to providing rules that can co-exist without market disruption does seem to be there.

“Mifid II [European financial market regulations] will deliver the G20 mandate to increase trading of standardized derivatives on transparent venues,” says David Bailey, the UK’s Financial Conduct Authority’s head of market infrastructure and policy. “Esma [the European Securities and Markets Authority] is currently

seeking the market’s input on the detailed transparency rules and liquidity criteria that will support this new framework across Europe. Key to the success of the new European rules will be the way that they interact with other regimes. The Mifid approach is fully consistent with international principles agreed by IOSCO in 2011, and I welcome continued close cooperation between regulators of the major markets.”

In the meantime, market participants are carefully monitoring regulatory progress around the world and trying not to worry.

“For the buy side, with exposure in Europe and the US, the lack of alignment between the MTF rule and the SEF rule is definitely a problem,” says Zohar Hod of SuperDerivatives. “Luckily I’m a software provider so it doesn’t bother me at all.”

Reppas says: “It is a concern that international regulators seem not to be working well together.”

Best says: “Ultimately the new regulations [globally] have their origins in the same place. And therefore we are pretty optimistic that we can make the rules reconcile and continue to achieve a global liquidity pool. That’s not to say that we aren’t tracking developments very carefully.”

Fitzpatrick believes IOSCO could have been more influential in the process of developing these rules. “IOSCO should have taken a more aggressive management role in the global structure and cooperative implementation of all of this,” he says.

No answers And it’s not just conversations between regulators that seem to be going awry. Market participants report frustrations when asking for clarifications on the rules in the US. One senior platform representative who did not want to be identified said the temptation was there to simply wait for the first round of enforcement actions to give some clarity on the complex rules.

But others report better experiences when talking through rule problems with those who created them. “In talking to the CFTC I am always pleasantly surprised by just how open they are to discussion,” says O’Brien. “They are making a real effort to understand the concerns of the market. Of course, it doesn’t always mean that they will agree.”

Others acknowledge the size of the challenge rule-makers face. “I think the reason that people can’t get answers to questions is because the people they are asking genuinely

“We will assess market conditions and work closely

with our customers to ensure our offering meets their needs”

George Harrington, Bloomberg

MARKET FOCUS


don’t know the answers and are still figuring it out,” says Burns.

“We’ve asked for guidance on certain things from the CFTC,” says Reppas. “I realize that over the last year they have been swamped; they’ve had a lot to do. They have done their best to respond to our questions but they have been under-staffed.”

For Icap, direct conversations with international regulators are going well. Earlier this year the firm launched Icap Global Derivatives Limited (IGDL), which is both a SEF and an MTF, meaning it is currently already regulated by both the CFTC and the UK’s Financial Conduct Authority (FCA). But that’s not the end of the process. “We are seeking permission to operate in Asia and Latin America, which will take time, as it does everywhere,” says Best. “We have to approach the authorities and seek licences to operate. It is difficult to know how long it will take to get approval. We’d like to be global as soon as possible.”

Data difficultiesOne of the hottest topics to address, as the SEF rules are adjusted and platforms look to go global, relates to the collection of data. The CFTC is open about the fact that it is currently not receiving adequate data about trades on SEFs. In the Euromoney poll most respondents said they did trust the data being gathered. But market participants, not to mention the CFTC themselves, know more needs to be done.

“The CFTC needs to issue some guidance to clarify what was intended for the data reporting,” says Burns. “That’s the purpose of guidance.”

Reppas adds: “There are many different places you can report to under the rules. The rules were not prescriptive enough and now direct comparisons cannot be made. That’s something we are faced with when we are trying

to see what our market share is. We’re going through all the websites and trying to convert data so we can see how our products are doing.”

He says that the market has rectified the problem itself to an extent, with some informal conventions having been established to offer more unified data.

But when it comes to the physical rules, crucial points such as the currency in which to report notional volume for FX trades, for example, are not specified. And when it comes to making comparisons between SEF and international SEF-type platforms, forget it.

Consolidation soonWith the market slow to take off, talk of mergers and acquisitions has begun. There has been turnover at the top of some SEFs and others that submitted registration papers to the CFTC appear not to be actively trading. They have perhaps decided the market wasn’t worthy of further investment, or possibly failed to attract clients.

“Customers are sticking with names they know when it comes to choosing a SEF,” says Fitzpatrick. “When there is that much risk in the marketplace you don’t increase it by going to a venue that didn’t exist six months ago. Start-up SEF’s have the mother of all uphill battles.”

Burns agrees that the newcomers have an “incredibly challenging” task. “Thomson Reuters

is successful because we already had a liquid platform and we just had to layer the SEF like an outer shell. We didn’t have to compete for new liquidity,” she says. “We had an existing customer base, and we simply had to convince them to continue using our platform with its new regulatory outer shell.

“A brand new SEF has to not only develop surveillance capabilities and technology that is robust enough to pass CFTC investigations but also has to convince customers to take a regulatory requirement that nobody wants. That’s a very tough sell.”

Reppas says: “We’re already seeing some of the start-ups facing some difficulties, the data speaks volumes. We wouldn’t be surprised to see some consolidation among SEFs in the coming months.”

Hod says: “I think there is going to be more and more adaptation [to trading on SEFs] but it’s going to be very, very slow and it’s going to be survival of the fittest. I believe we’ll see a flight to quality, only the strongest SEFs will make it.”

Most of those Euromoney spoke to say they expect consolidation, Icap’s Best predicts that the market might ultimately shrink to just four SEFs. He says: “SEFs have been going since October last year; for both customers and SEFs there are cost pressures relating to on-boarding and doing business. There are also considerable additional costs to run a platform as a SEF. I think people are beginning to evaluate whether it’s worth being a SEF anymore. Some will get consumed by others, others will disappear altogether.”

Fitzpatrick says: “SEF rules will concentrate liquidity, which isn’t bad so long as you don’t concentrate it too far. You’ll see very little liquidity moving downstream; it will be moving up to the

“The most important thing is to get the clearing part sorted,” says Reppas. “Most people who are thinking about joining a SEF probably aren’t currently clearing their products; they’re doing bilateral trades. They need to do all the relevant due diligence and get familiar with clearing.”

Hod adds: “One of the major effects of this legislation is that clearing is no longer an afterthought. The trader has to think about where he is going to clear before he starts to trade.”

Advice for newcomers to SEFs CLEARING

“We are beginning to think about how we will accommodate

execution level requirements”

Peter Best, Icap SEF

MARKET FOCUS


incumbents, and between them as well. But as long as you allow flexibility and competition in an environment that breeds innovation, the rest takes care of itself.”

You might think all the talk of consolidation would worry UBS and its aggregator model. Not so according to Russell. “Even if we envisage a marketplace with only one SEF for each product – FX, IRS and CDS, clients would still come into NEO and be connected to all three through a single platform,” he says. “We think there is a lot of uncertainty around consolidation, winners, and ultimate sources of liquidity, and the timing of change. Whatever happens, we feel we have a solution that will continue to provide benefits to our clients.”

Even the process of joining a SEF could become a reason for consolidation according to Best. “SEFs will need to be more demanding with membership, documentation, and member investigation and surveillance,” he says. “As these become more routine, I think members will start to think about on-boarding with fewer SEFs in order to avoid the general hassle of audits and compliance to multiple entities.”

With fewer customers, some SEFs might be forced to close.

Fractured liquidityCompetition is increased further by the difficulties involved in the split between US and non-US participants, which has caused a severing of liquidity between trades taking place in the US and elsewhere.

“The dealer community now is structuring their business into a US-persons business versus a non US-persons business,” says Reppas.

This, Best says, was the reason for establishing IGDL. “IGDL is dubbed the global SEF, its purpose is to reconcile the SEF rules with local regulation around the world and piece together the fragmented liquidity.” He believes others will follow in Icap’s footsteps: “We would expect to see competitors following our lead. It is a solution to fragmented liquidity.”

For now the split is creating an interesting situation on trading floors. “We’ve seen split liquidity by which most of the world is trading off-SEF in FX until the US hours when a lot of US dealers open up their dealing books and we see more SEF participation,” says Best. “It is still interdealer focused at the moment.”

Reppas agrees. “You can see that shift,” he says. “We have a very good presence on our SEF in the US. So in the morning in Europe, there is much less SEF trading activity. SEF operations start at 3am US time, but trading simply doesn’t happen then. It doesn’t cause us any problems

because we have a complete team in London and the US that can support SEF trading when it’s active.”

Developing the rulesThe future expansion of SEF rules worries everyone involved, but it was FX market participants that were most vocal in their consternation. Although admittedly the FX market has had the luxury of watching how the other asset classes have adapted to the world of SEFs, there are still questions about how and when the types of FX instruments to be traded on SEFs might be expanded.

When the first rules were proposed there were questions about why NDFs and options were chosen to be traded on SEFs. They are the most complicated of FX instruments, and the smallest part of the electronic FX market.

“My personal view is that the regulators picked them because those products were guinea pigs,” says Burns. “You don’t want to mess up the forwards market. So NDFs and options impact a smaller percentage of the FX market space, while the regulators get it right. After that I believe the CFTC will welcome expanding the SEF scope to cover other instruments, but only once they are comfortable they’ve got it right.”

O’Brien says: “I don’t think NDFs are ready for a trading mandate. There are too many complications for SEFs and I don’t think there are enough alternatives. Until you figure out the problems with the rules in place, why would you add new asset classes? You don’t have to solve all the issues, but the big ones at least need to be tackled before we jump into NDFs.”

Burns echoes the hope that any expansion won’t be rushed. “I think the regulators are going to be very ginger in light of how they expand the trading mandate,” she says. “This is a multi-year initiative. It could be five to seven years before we have additional FX instruments [beyond NDFs and FX options] trading on-SEFs. I don’t think many of the start-up SEFs will have enough cash to make it to that point.”

Bloomberg’s Harrington wouldn’t be drawn into guessing what might come next, vowing to

be prepared for anything. “Bloomberg has been in continual contact with relevant authorities regarding the evolving market and what we believe makes the most sense in terms of trading mandates,” he says. “We see a key part of our mandate is to prepare clients for future regulatory requirements and deadlines. We will assess market conditions and work closely with our customers to ensure our offering meets their needs.”

Educating the massesWhatever is coming for SEF rules, one thing all the SEFs Euromoney spoke with agreed on was that the education of clients is paramount. “They have to understand why we are asking them to sign up to these rules,” says the CEO of one SEF.

“We were holding weekly meetings in the beginning to educate our salesforce and as a result our end clients,” says Reppas. “We’ve also held client seminars to help everyone understand the rules. It’s been an interesting process.”

Harrington says: “By the time our SEF began trading last October, Bloomberg had spent years educating clients and industry participations, and working with regulators, regarding the transition from over-the-counter to SEF trading in swaps and derivatives. We held one-on-one client sessions and large-format events, and published white papers and other content to keep our clients informed about the coming changes.”

Burns says: “Thomson Reuters’ approach to regulation is: given that customers face new legal and operational pain resulting from regulations, how can we try to absorb as much of that pain as possible to remove it as being a blocker to doing business with us. I think that’s why we are

“There was certainly a moment in time where we were dealing

with global chaos”

Scott Fitzpatrick, Tradition SEF

MARKET FOCUS


successful.” Reppas notes that the buy side is learning

by doing, with the hedge fund community leading the way as active clients and more traditional asset management firms still trying to adjust their processes. “On quieter trading days you see buyside firms experimenting,” he says. “We regularly see clients trading through our anonymous protocols. Many of which, after the transaction is done, will question us for the counterparty of the trade. They simply cannot comprehend that they could trade anonymously with someone else. It’s a learning process, we’re getting there.”

Talk to meIt’s not just better communication with clients that needs to take place. SEFs and the buy side alike want to see a coordinated effort to talk to the CFTC about their concerns over these rules and the scale of the changes taking place.

“This is a radical shift to market structure and these things can’t be done successfully

overnight,” says O’Brien. “The buy side needs to be more vocal about what they think. There are fewer banks; they can organize themselves more easily. For the buy side you have big firms like BlackRock, Fidelity and Vanguard, you have nimble hedge funds, middle-sized funds and so on. There are some trade groups representing parts of the market, but the buy side generally is not well organized. I don’t know if by the end of the consultation process the same message was getting through from the buy side to the CFTC.”

Burns says: “We think there should be an industry conversation about how data should be reported. We all have a vested interest in having apples-to-apples comparisons made; we all want to be judged on market share. So let’s have a conversation to agree on that.”

Many other SEFs were keen for this to happen, including MarketAxess, Icap and Tradition.

“We would be interested in being involved in an industry discussion about how data should be reported.” says Fitzpatrick. “But I don’t think the SEFs should be the ones to decide what is

reported. How and the uniformity of it we can help with.”

However, there are problems facing this, as Burns notes: “[Unfortunately] There’s no mechanism for having that conversation. If I were to call the other SEFs to talk about this, it would be seen as collusion.”

Despite all the troubles getting to this stage of the process of introducing SEFs, and the undoubtedly bumpy road ahead, there are signs things are improving. Trading data is starting to pick up and interest from around the world is growing as market participants accept that these rules are here to stay.

“These rules aren’t going away and they are going to change day-to-day business whether you like it or not,” says Burns. “Just get on with it. You can rile at how silly this or that is, but it won’t change anything. You need to figure out a way to minimize pain, serve clients better, and find the upside to regulation, because it is not going away.”

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SEF SURVEY RESULTS: FX MARKET


Trading on SEFs in the FX market has understandably got off to a slow start. After all, not many instruments are available for trade this way. The concept was simple: under the Dodd-Frank Act, in order to promote market transparency, certain over-the-counter derivatives products must be traded on a SEF and cleared through a central counterparty. In the FX market, the instruments first brought into this regime were options and non-deliverable forwards (NDFs); others are expected to follow.

However, many market participants are choosing to trade off-SEF. This was clearly shown in the data gathered for this report. Less than a third of those who took the survey said they were trading FX on a SEF.

The CFTC envisaged a market where competition was high and participants had a

choice of platforms and access to the very best prices as a result. Our research has not found this. Just one respondent is trading on five or more SEFs. The majority prefer to

choose just one platform to partner with. Our impression is that most market participants at this stage seem to be testing the market; more likely not willing to go through the hassle and expense of on-boarding with any others after going through the process once.

Data available from the Futures Industry Association and other publicly available sources point to a handful of SEFs dominating in the FX market. This was very much supported by the responses to the Euromoney survey, which show that Bloomberg, FXall, Tradition and GFI Group topped the poll.

It is fairly clear from our research that there will be a slow increase in the volume of FX trades, but this is not likely until more instruments are made available to trade. When asked how market participants expect their volume of FX trades completed via SEFs to change, on the whole the responses pointed to increasing volumes, but slowly over the next year, with a bigger jump in the coming five years. It is possible the market is following the widely held expectation that more FX instruments will become available for trade on SEFs, or that a strict mandate will be introduced during that period.

✪ Slow market adoption to continue✪ Participants choosing to trade on one SEF only – undermining hopes for a market brimming with competition ✪ Volumes are expected to increase less over the next one to two years; increases seen as likely to accelerate over the coming two to five years

SEF survey results: FX Key points

SEF SURVEY RESULTS: FX MARKET SEFs STRUGGLE TO GAIN TRACTION WITH CLIENTS

Now One year Five years 10 years

Percentage of FX volume traded on SEF

0

10

20

30

40

50

%

Expected percentage of FX volume traded on SEFs

Source: Euromoney Research Group

SEF SURVEY RESULTS: FX MARKET


Market participants respond to introduction of SEF rulesOne of the biggest initial fears for everyone involved in this market, not least the CFTC, was that implementing SEF rules would have a detrimental impact on business flows. Our research suggests that has not been the case, which will be a big relief to US regulators. Start-up SEFs may be grumbling about slow buy side uptake and struggling business plans as a result, but those trading via SEFs seem unfazed. The majority say the rules have not affected business at all; others imply a positive effect. The most negative responses were a handful of votes for the rules having had a “mixed” impact on business.

Respondents displayed varying levels of confusion over the SEF rules. While SEFs and those implementing the rules directly seem to have had more trouble, clients of SEFs seem blissfully unaware, with most claiming to be only either “slightly” confused or “not confused at all”.

Interestingly, the bulk of the responses to a question about whether internationally accepted rules might be possible indicated that they would be. We are not sure regulators around the world would agree. Cooperation has been painful and talks have achieved little. Letters are publicly being sent back and forth, particularly between the US and European authorities responsible for market oversight, but so far to no avail.

Data collection is still causing a problem for the CFTC. The rules were woefully inadequate in stating what information it wanted to gather

and how. The result has been that the regulators currently have no meaningful data stream coming in from SEFs and no way of making useful comparisons between them. Additional guidance on how SEFs must report is widely expected in the future, but the majority of those answering the Euromoney survey said they thought the numbers being distributed by the SEFs themselves could be trusted, despite this information not being entirely uniform.

There was little expectation for much market change beyond the concentrated bunch of SEFs currently presiding over FX trades. Just three respondents expected to see more SEFs becoming competitive. The long-standing players that dominate this field are expected to remain strong and when it comes to a start-up trying to break into the limited liquidity in this area, well, good luck to them.

When it comes to cost there was more positive news for the FX market; most said the

introduction of SEF rules had not had a cost for their business. And again the majority thought costs would remain the same in future, which is good news indeed when costs are zero.

Majority still trading off-SEFFor the more than two-thirds of respondents who are yet to trade on a SEF, the reasons were mostly straightforward.

“As a manufacturer, we only do simple straightforward currency forward contracts with banks,” said one. “Company policy” was the reason given by another.

Respondents hailed from all over the world. One from Algeria said negotiations with banks were under way to gain access to SEFs.

A number of international respondents did not know what a SEF was, indicating the scale of the education efforts that still need to be made in markets such as India.

Asked what would lead to those who do not trade on SEFs changing their stance, the most popular response by far was a rule change to make trading this way mandatory.

“A regulatory requirement. Other than that, nothing,” said one respondent.

Others looked more to internal policy, one saying “instruction by HQ” was the only reason trading would shift to a SEF.

Global trends were also noted as important, wanting to see others try out the system first presumably. Larger trading volumes were also highlighted as a reason that might make moving to trading on a SEF viable.

Do you trade FX on a SEF?

Yes 31%

No 69%

Do you trade FX on a SEF?


Yes No

Do you trust the data being gathered about FX trading on-SEF?

0

25%

50%

75%

100%

Do you trust the data being gathered about FX trading on-SEF?


“We only do simple straightforward currency forward contracts with banks”

SEF SURVEY RESULTS: IRS MARKET


Early in 2014 various types of interest rate swaps became mandated to trade on SEFs. As a result this market is seeing very different uptake of trading on SEFs compared with FX. However, given the international reach of this Euromoney report, we had a number of responses from people who are not trading on SEFs. What they had to say is interesting and at times shocking.

One respondent from China said that while at the moment using SEFs was not necessary, when trading interest rate swaps in currencies other than renminbi, not using the facilities might prove “inconvenient” in the future.

For Europeans, the decision not to use SEFs was straightforward. “We only invest in euros. We comply with European regulation,” said one. “Our company is based in Europe; we don’t trade US swaps,” said another.

A Japanese respondent said quite simply that the reason he isn’t trading on a SEF is because the installation of SEFs is not required by the authorities in Japan.

For many it seems a black-and-white decision: until I have to, I won’t. For “US persons” however, or those wanting to trade with one, that time is already here.

Bombshell reasons for trading off-SEFSEF providers and regulators might be concerned by some of the responses from those still avoiding SEFs. Some have ceased trading SEF vehicles altogether since the regulations became mandated, finding other ways to carry out their business. Even more worryingly, one says he trades over “chat” services on Bloomberg. “That works fine, so we see no reason to change that,” he says. In the light of recent events in the FX market and the impact of chat rooms (on services such as Bloomberg), though, banks might be loathed to continue this practice (many have already stopped).

Lack of instrument coverage was also highlighted as a reason to stay away from SEFs.

One European respondent lamented not being able to efficiently trade “structured IRS swaps [or] trade packages” on SEFs.

Other international respondents indicated that the volumes they trade do not support

making the move. One said his company lacked the internal systems to shift and “[we] don’t do enough volume to justify [investing in them]”.

“We are a small company, we have a small fund management operation that does not

SEF SURVEY RESULTS: IRS MARKET INTERNATIONAL PLAYERS SLOW TO ADAPT

✪ Bigger increase in volumes traded on SEF expected over two to five years than in the next one to two years✪ International interest in trading on SEFs is growing but educational efforts must continue ✪ Majority trading on one SEF only; leading to concerns for competition ✪ Trades are still happening over “chat” functions, side-stepping the tighter SEF regulations altogether

SEF survey results: IRS Key points

Geographical breakdown of IRS survey respondents


SEF SURVEY RESULTS: IRS MARKET


require the use of professional tools,” said another.

Why choose to shift to SEFs?Peer pressure was suggested by one respondent as being the reason his company would start trading on SEFs. “If more and more counterparties need to trade IRS on SEFs, it seems we must choose one SEF to continue trading”. The specificity of choosing a lone SEF will interest the market. From the start, the hope has been of creating a marketplace with as much competition and choice as there had always been. But if the arduous process of on-boarding and slow uptake from the buy side means this isn’t possible, we could end up with a monopoly of a very small number of SEFs.

Others pointed to regulatory change as being the only thing that would make them trade on SEFs. “Introduction of mandatory use of SEFs in Europe,” was the only way to get one respondent interested.

Others wanted to see “reliability”, “convenience” and “better prices” from SEFs before making the move.

“Greater flexibility [and] meaningful liquidity benefit leading to changes in portfolio structure,” said another respondent.

“We see the potential need to trade SEF mandated vehicles in the future, but are not interested [at the moment],” said a US market participant.

The transparency of trading this way was highlighted as being an attraction, with one

prospective SEF client saying he thought it would “prevent a mistake of order”.

Many still choosing to trade off-SEFAs with the FX market, we found the majority of respondents are yet to trade on SEFs. This was unexpected in the IRS sector, as certain instruments have been “made available to trade”, which means they have to be traded on SEFs. However, the answer lies in where our respondents are based. As the map shows, we heard from people all over the world, many of whom will not be touching the US market, and therefore the Dodd-Frank rules.

In terms of market competition, we were concerned to discover that most market participants, even in the more mature IRS market, are using only one SEF. It is possible they trialled others before settling on their favourite; more likely they went to the biggest players, or relied on existing relationships when the rules came in. This suggests that start-up SEFs might find it hard to compete, which can only be bad news for the market in terms of encouraging innovation in products and technology. Struggles with innovation were highlighted in the FX survey as being a big hindrance to newcomers wanting to join the SEF trading world.

Five-year expectation for notable increase in volumesThere was a strong majority in answer to the question about how the percentage of volumes traded on SEFs would change in the coming

Are global SEF-type rules possible?

No: 75%

Yes: 25%

Are global SEF-type rules possible? (IRS respondents)


Yes No

Did the introduction of SEF rules have a cost for your business?

0

10%

20%

30%

40%

50%

Did the introduction of SEF rules have a cost for your business? (IRS respondents)


years. Market participants clearly expect to see these increase, presumably as more and more of the market becomes mandated.

There was a bigger change between the position now and in five years than in the next 12 months, indicating a prolonged adoption period of this way of doing business.

Respondents noted little impact on their business by the change in rules, with just one saying the introduction of SEFs had had a negative impact. And in further good news for the SEFs and their educational efforts, the majority were “not confused at all” about the process of shifting to trade on SEFs.

International rules a no-goFX market respondents said they thought internationally agreed rules might be possible. Not so for those responding to the IRS survey. The more experienced IRS market gave a resounding “no” answer, demonstrating their understanding of the difficulties.

Three-quarters of respondents said they trusted the data being gathered about trading on SEFs. And the same proportion expected no change to volumes of trade being concentrated on a small number of SEFs.

When it comes to cost, those trading IRS in a mandated environment more often saw a cost to their business and they also predict a rise in costs over the next five years. Perhaps it is a sign of what is to come for the FX market as and when more instruments are made available to trade.

nsigh u i d i t y l i q the state of the sef market...to trading on sefs and what market...

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