Major banks move to aggregate swap execution facilities

The Dodd-Frank Act created a multitude of would-be swap execution facilities (Sefs) – trading platforms that will aggregate dealer liquidity. Now, dealers want to hoover up the Sefs by building their own aggregation services, but it’s a strategy that could force the over-the-counter derivatives business into strange new territory. By Duncan Wood

The golden age of the swap execution facility (Sef) is over. It lasted less than a year and ended before any Sefs had actually opened for business – or so dealers would have you believe. When the Dodd-Frank Act was signed into law on July 21 last year, it made it obligatory to execute clearing-eligible over-the-counter derivatives trades on an exchange or Sef – defined as a system or platform that brings together multiple participants on both sides of the market. In fewer than 100 words, the relevant sections of the legislation relegated dealers to the role of homogeneous price providers, with Sefs becoming the new shop window for the OTC market.

Perhaps. Dealers argue their customers won’t want to connect to more than a handful of Sefs, but also won’t want to miss out on the liquidity spread across this fragmented market. With as many as 20 Sefs now waiting in the wings, there’s a role for an aggregator. Enter single-dealer platforms. Robbed of their ability to execute clearable trades by Dodd-Frank, these platforms could now gain a new lease of life as super-Sefs, collecting prices from competing venues and once again making banks the gateway to the OTC markets. In essence, Dodd-Frank enabled Sefs to leapfrog the dealers – and dealers now hope to pull off the same trick.

“We’re discussing internally how to be the aggregator. We’re trying to find a way to make it easy to execute across cash, futures and OTC markets as a way to separate ourselves from the Sefs,” says Rhom Ram, the London-based head of Autobahn, Deutsche Bank’s single-dealer platform.

Deutsche  Bank is not alone. E-commerce specialists at five other banks all argue that dealer-run aggregators will be the way clients choose to access the market, and one claims to have a beta version of a Sef aggregator up and running already. “Sefs will appear and this will change what we offer to the client,” says Ian Green, head of e-commerce for fixed income, currencies and commodities at Credit Suisse. “In some markets, we’ll continue to use our risk management expertise to offer clients tight executable prices, while in other markets we’ll serve the client better with aggregation and routing expertise. If the question is how to get clients the best access to liquidity that’s fragmented in different places, we see that as an opportunity more than a problem.”

If it’s not a problem for the banks, it is for some of the Sefs. In particular, existing trading platforms such as Tradeweb and MarketAxess, which already allow users to trade with a number of different dealers, don’t want to be locked away behind someone else’s platform and compete with other venues for a share of the flow.

Asked whether Tradeweb will allow itself to be aggregated, the company’s New York-based president, Billy Hult, is fairly unequivocal: “One of the main reasons for forming Tradeweb was to pool dealer liquidity, and we’ve now been providing institutional investors with an electronic request-for-quote for more than a decade. With all the major swaps dealers already making markets to their clients on Tradeweb, it’s hard to see the benefit of Sef aggregation to end-users.”

Richard McVey, chief executive of MarketAxess, which offers electronic trading for bonds and credit default swaps and plans to expand into interest rate swaps as a Sef, says the future he envisages is one in which users come directly to the platform to trade. “We’ve been successful in aggregating a total of 80 dealer market-makers that are active on our system. Once you get to 80, there’s not much left to aggregate. We think of ourselves as a super-Sef already for credit,” he says.

Other multi-dealer platforms are sitting on the fence. Would FXall allow its prices to be aggregated? “Well, possibly,” says chief executive Phil Weisberg. “It would come down to the aggregation rules and whether we can be successful in that environment. We’d prefer not to be aggregated if the differentiating features of the platform were lost. But realistically, people are unlikely to buy the value proposition of aggregation until we know how many Sefs there are and that they’re viable.”

One bank’s e-commerce head argues that Bloomberg ought to be particularly worried by the prospect of Sef aggregation: if market participants can go to a single entry point and access practically all OTC derivatives liquidity, they may decide they don’t need a Bloomberg terminal on their desktop. Ben Macdonald, Bloomberg’s global head of fixed income, claims not to be losing sleep – and says the company itself could conceivably act as a super-Sef. “Aggregating is distribution. I’m not sure I have a view on whether that’s a good or a bad thing for us. At the end of the day, we’ll probably go where our customers want us to go – and I could envisage a scenario where we provide aggregation of different Sefs over the terminal, but it’s not somewhere we are right now,” he says.

In essence, everyone is fighting over the same thing – relevance to customers – and there’s a widespread belief among both dealers and Sefs that relevance is bequeathed by enabling clients to execute whatever they want, whenever they want, at the best price available. Sefs try to achieve that by aggregating multiple dealers and putting them in competition. Dealers are now preparing to do exactly the same thing with the Sefs themselves. Whether Sefs like the idea or not, the logic is irresistible, bankers say.

“Ultimately, if everyone does this, the Sefs and exchanges will be required to adapt. If most of the liquidity is coming through consolidators – three of them or five, or however many there are – then that will drive the model,” says Paul Hamill, chief operating officer for US credit trading at UBS in Stamford, Connecticut.

It may make sense, but that doesn’t make it easy. Even if Sefs can be persuaded to play ball, aggregation faces a host of questions: how to commingle different types of price, for example, and whether regulators will smile on the concept. Arguably the biggest challenge, though, is the cultural and organisational shift that will be required.

Sef-aggregators already exist in cash equity and listed derivatives markets, although not by that name. It’s common practice for agents to provide clients with access to various stock and futures exchanges and then bolt on an array of associated services and products, such as algorithmic tools that split execution across a number of venues to get the best all-in price. But this business model is alien to the OTC market, dealers admit. It is hard to imagine a bank that may have spent upwards of $100 million developing its platform happily using the technology to direct its clients to an array of Sefs, where they could end up executing with rivals – at least, it’s hard to imagine the bank’s traders being happy about it.

“If you’re saying to people ‘here is our portal – we’ll help you find the best liquidity’, then you have to be prepared for the fact that the liquidity on the other side might not be your firm’s liquidity,” says a senior operations executive at one bank. “You might be bringing in 100 orders a day and other banks might be filling 95 of them. So everyone will build the technology, and I think it will be driven a lot by sales and prime services and groups like that, but the trading mindset is where the challenge lies – a lot of those guys will still be out there wanting to fight for the order.”

This picture isn’t necessarily rosy for the firms winning the execution business either – they may be jealous that their involvement with the client is limited to making a price, says Bloomberg’s Macdonald. “What’s being suggested is that as a client of dealer A, I can access the liquidity of a series of other dealers on A’s platform – and the obvious issue with that model is, who owns the client relationship? If dealer A and B compete for the same client base, does B want A to be the guy who has desktop real estate with his client? Probably not.”

Dealers expect this cultural shift will need to be accompanied by an organisational one, with users of an aggregator demanding some degree of separation between a bank’s agency and principal business. The head of rates at one European bank argues there will need to be strict Chinese walls between the two, because clients will not want their trade data to be visible by the principal business of the bank providing the aggregation service.

Banks may need to go further than just protecting client information, argues one dealer. “Building a Sef-aggregator is the easy bit. The hard part is how you set up an agency business model alongside a market-making business model. And it isn’t clear to me they can be the same business. That’s the bit I think people will find it hard to get to,” says the operations executive.

Banks may need to create a separate management team and governance structure for the venture, he argues – a strategy that may be necessary to make an aggregator work, and may also open more doors. “Where things might get interesting is if dealers are open to the idea that some sort of agent could be allowed to find their non-Sef liquidity as well. That’s why I think the precise identity of the aggregator is important. If I went to JP Morgan tomorrow and told it I was setting up an aggregator that would capture the prices it puts on Sefs, it would say ‘fine – we can’t stop you’. But if I said that I’d also like to show my clients JP Morgan’s axes, its off-the-run stuff, its cash positions, it would say ‘not a chance – you’re a rival, why would I do that’. And the answer to that is that I’m not a rival bank – I’m an agency business and I’m representing clients independently of the market-making business. That’s when this model really gets taken to its extremes, and is where it could really start to make a difference,” he says.

That’s if Sef-aggregation is possible at all, of course. Some speculate that the aggregator model wouldn’t be allowed by regulators such as the US Commodity Futures Trading Commission (CFTC) – although there’s nothing explicitly forbidding it at the moment. If banks want to promote their own platforms as a gateway to Sefs, a regulatory specialist at one interdealer broker argues those platforms would need to meet the same data management and data monitoring standards as the Sefs themselves.

FXall’s Weisberg puts it more pithily. “Can you be a Sef of Sefs without being a Sef? If we’re a Sef and are trying to comply with the regulations, wouldn’t we need to regulate the aggregator too? You could see this as taking away the ability of the CFTC to approve the execution mechanism by creating a new one,” he says.

There are practical problems, too. Sefs will be allowed to use two broad types of trading protocol – request for quote (RFQ), as used by existing multi-dealer platforms, and central limit order books, as used by exchanges – but the two approaches generate prices that are not necessarily comparable, dealers say.

In an RFQ model, a user will ask a dealer to provide a price for a given trade and then choose which to accept – in other words, the quotes provided are completely firm and the decision to execute is ultimately the user’s. Central limit order books potentially require dealers to offer streaming, constantly updated prices, but are relatively new to the OTC markets. As things stand, when dealers provide streaming OTC prices electronically today, they typically come with a ‘last look’ for the provider. So if a user wants to trade against a given price, the final decision to execute is the dealer’s. That’s a problem for would-be aggregators, says Andrew Challis, head of rates e-distribution and strategic investment for fixed income, currencies and commodities at Barclays Capital in London.

“Commingling the two protocols is actually very, very challenging. Do you allow the central limit order book to stand in front of or alongside the RFQ responses? With the former, the dealer has the last look and with the latter it’s on the client. If you commingle, you’d probably have to force the streamed liquidity to be 100% firm, which means it wouldn’t be subject to credit-checking or last-look,” he says.

Jamie Cawley, chief executive of Javelin Capital Markets – a start-up trading platform that has its eye on achieving Sef status – says this contrast between protocols means his firm can’t be aggregated with its competitors. “When we look at the market, we see MarketAxess and Tradeweb as our primary competitors, both of which are RFQ. Our model is central limit order book first, RFQ second – so where they don’t have live prices, we do, and it’s tough to aggregate live prices with ‘on the wire’ quote requests. It doesn’t mean they won’t have live prices in the future – we expect they will – but not at the moment,” he says.

Last, but by no means least, dealers will have to work out how to make Sef-aggregation pay. One e-commerce head says his bank estimates execution profits will be cut by 20% in the new regime – a combination of thinner bid-offer spreads on cleared business and more consumption of capital for uncleared positions. One way to recoup some of that lost profit is to mimic futures or equity-market agents and charge commission to users of an aggregator, but that would be a leap for OTC businesses, dealers say.

“Commission – we don’t know what that word means in fixed income,” says David Bullen, London-based head of e-commerce for Citi’s global rates and credit business. “When you start talking about applying a futures model, where you charge a turn on the way in and out of markets – effectively a small commission – fixed income isn’t set up to do that on either the buy or sell side. On the front end, accounting systems and the format of confirmation messages would need to be changed, and on the back end there are considerations such as tax implications of charging and accruing an explicit commission.”

A senior trader at one large European bank says his team has been discussing three different approaches. The first would be to charge a connection fee to users of an aggregator, possibly determined by monthly usage of the service, on the basis that the bank is doing the hard work of hooking clients up to a multitude of different venues. A second idea is to make the service free for clients, but then to expect a certain proportion of their business in return – although, in practice, regulators may prevent clients selecting a single preferred dealer for clearable trades. Finally, Sefs could pay the banks if volume comes their way from an aggregator, he says.

Whatever the industry’s choice, observers have no doubt that dealers will find a way to recover much of the profit that regulation is set to erode – by charging for aggregation and associated services, but also through the various tasks dealers will perform for customers when acting as their clearing broker.

“What they’ll provide is end-to-end execution and clearing services for their clients,” says a strategy director at one large interdealer broker. “So, you decide what you want to trade, then you submit that trade to your dealer and they get it done and cleared for you in any way, shape or form – and all you know in the end is that you’re done. I think that’s the way it’s going, and there are quite a lot of places in that model where they can charge. I’m sure banks will find a way of charging their clients.”

Backing aggregation

If multi-dealer platforms are wary about being aggregated, there’s more enthusiasm – albeit guarded – from other would-be swap execution facilities (Sefs) and from alternative venues that aim to serve the post-Dodd-Frank derivatives market.

Eris Exchange was launched in early 2010 by a group of five high-frequency trading firms. The venue, which would be regulated as a designated contract market under the terms of the Dodd-Frank Act rather than a Sef, allows users to trade futures contracts that aim to replicate the economics of an over-the-counter interest rate swap.

“We see a world where users trade OTC cleared swaps on Sefs, but also bundle it with our futures product. If a user wants a bespoke product, they can go to a Sef and request a quote. But if they want central limit order book execution in liquid, plain vanilla products, then our market is a viable solution. That’s how we see it, and we’ve had a number of platforms actively talking to us about carrying our product on their Sef,” says Neal Brady, chief executive at Eris Exchange in Chicago.

Raymond May, a former swaps trader and head of US rates at JP Morgan, unveiled his own proto-Sef, Odex, in January this year and has been visiting New York on a monthly basis from his home in Charlotte, North Carolina, hoping to generate dealer interest in the platform.

Would he allow prices on Odex to be aggregated in competition with prices provided by other Sefs? “Sure. We’re all for that,” he says. May has also had conversations about pairing up with other trading venues, but he says any decision on such a move is some way off.

Javelin Capital Markets is one of the best-known of the Sef hopefuls – partly because of the vocal pro-competition stance of the Swaps & Derivatives Market Association, which was co-founded by Jamie Cawley, Javelin’s chief executive, and has ruffled feathers at the big dealers. Cawley is less keen on the idea of aggregation. “Now you’re asking the $64,000 question. Javelin is fundamentally indifferent about where the buyer and seller come from, as long as Javelin gets the trade. When it comes to putting us in competition with a similar Sef or a number of Sefs – we’re already in competition with them, whether it’s under one roof or several,” he says.

Other would-be Sefs are waiting to throw their hats into the ring. Attending a recent round-table event organised by the Commodity Futures Trading Commission and the Securities and Exchange Commission, Phil Weisberg, chief executive of FXall, says he counted 17 attendees with ambitions to launch a Sef. “I thought, how are they all going to differentiate themselves?” he says.

They’re not, says one senior market structure specialist at a US bank: “Everyone and his uncle in a garage is having Sef dreams, and the vast majority of these random, start-up proto-Sefs will fail and be of no interest to anyone.”

 

Swap execution facilities (Sefs) FAQ
Where did Sefs come from?
Politicians at the 2009 Group of 20 summit in Pittsburgh called for all standardised derivatives to be traded on exchanges or electronic trading platforms where appropriate by the end of 2012. The Dodd-Frank Act, signed into law on July 21, 2010, made it illegal to trade clearing-mandated derivatives anywhere other than a Sef or an exchange.

So, what is a Sef?
According to Dodd-Frank, it’s “a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants”. The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have to put flesh on those bones.

How are they doing?
The CFTC proposed its rules on January 7. The SEC followed on February 2 – its rules apply to security-based swaps, which include credit default swaps, total return swaps and equity variance or dividend swaps on single names or baskets of up to nine names.

After being reopened at the start of May, the CFTC’s comment period will now run through to June 3.

Do the two regulators agree with each other?
No. Both would allow Sefs to trade using request-for-quote (RFQ) or central limit order book models, but the CFTC calls for any RFQ to go to a minimum of five price providers, while the SEC says RFQs can go to a single provider.

Where is Europe on this?
Lagging. On December 8, the European Commission (EC) published a consultative paper for its review of the Markets in Financial Instruments Directive (Mifid), which proposes that all clearing-eligible derivatives should be traded on exchanges, multilateral trading facilities or “a specific sub-regime of organised trading facilities, to be precisely defined in Mifid”.

Exactly what these facilities might look like is a hot topic at the present time. The consultation paper says they should allow non-discriminatory multilateral access, but doesn’t appear to disqualify single-dealer venues – a stance that would create a significant transatlantic disparity in the way derivatives can be executed. Market participants expect the EC to publish its draft directive in July.