Sefs threaten dealer-client relationship

Some dealers are worried the proposed rules for swap execution facilities will drive a wedge between dealer and client, fundamentally changing the relationship in ways that might not be to the benefit of end-users, as well as the banks. By Peter Madigan

Everyone in the industry knows the Dodd-Frank Act will lead to massive changes in how the derivatives markets work, but dealers are becoming increasingly nervous the rules may change the market far more than they had thought. One worrying implication – at least for banks – is that customer relationships may be undermined by the arrival of swap execution facilities (Sefs). Specifically, a proposal by the Commodity Futures Trading Commission (CFTC) will require a request for quote (RFQ) to be sent out to a minimum of five potential counterparties – suggesting dealers will be thrown into mandatory competition on every cleared transaction.

“It will be a fundamental change to the way the swap market works today. One of the greatest things about this market is that you can come and do a trade for an end-user and you show them a price and it’s done. End-users may not be satisfied with having to work with multiple dealers. We are concerned the concept of single execution might be eliminated,” says a senior interest rate derivatives trader in New York.

The full implications are unclear – not least because the Securities and Exchange Commission (SEC) has been tasked with writing separate Sef rules for security-based swaps and proposed on February 2 that RFQs can go to a single counterparty, so long as the platform also provides the ability to send out a broader RFQ (see box). But dealers worry the CFTC proposal – dubbed ‘RFQ5’ by the industry – will make it more difficult for them to control and own the client relationship. That ownership allows banks to potentially charge more, but it also encourages them to offer a broad range of services, some of which clients will be sorry to lose, dealers argue.

As an example, banks will currently accept execution risk on behalf of their clients, quietly executing large trades over a period of days and sitting on the accumulating exposure for some time before trying to offset it. But because RFQ5 is combined with new proposals on pre- and post-trade transparency, dealers may now be unable or unwilling to perform this role: transactions qualifying as block trades are exempt from pre-trade reporting requirements, but will still be caught by post-trade reporting, alerting the market to the fact a dealer is sitting on a large position it may now need to hedge.

“These changes will transfer the burden of execution risk from dealers to the clients, and depending on where the requirements for RFQ5 and block trading come in, clients are going to have to become accustomed to owning their own execution risk, and making decisions on how they transact in sub-block sizes and whether they actually start asking for multiple RFQs from multiple dealers. That will be a big change from how clients operate,” warned Harry Harrison, head of rates trading at Barclays Capital in New York, during a panel discussion at the annual meeting of the International Swaps and Derivatives Association in Prague last month.

Harrison also argued that RFQ5 could jeopardise the provision of other services, such as analytics, advice and research, because dealers will no longer be able to expect to win a share of a client’s business.

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Sefs threaten dealer-client relationship