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Dealing with Swaps

Published in Automated Trader Magazine Issue 37 Summer 2015

Swap execution facilities have been somewhat of a slow burner. Even now as they pick up steam, a request-for-quote system remains the popular choice. But a regulatory preference for central limit order book trading means that exchange-like structures will gain prominence as the swaps market place evolves both in the US and Europe. It could also mean a ramp-up in buy side seeking viable hedging alternatives. Anna Reitman reports on how it's all playing out for market participants.

Mark Wetjen, Commissioner, US Commodity Futures Trading Commission

Mark Wetjen, Commissioner, US Commodity Futures Trading Commission

If you ask CFTC commissioner Mark Wetjen to describe the ideal SEF marketplace of the future, he'll tell you that a vision could look like the futures exchanges today - deep liquidity, active trading, ease in getting in and out of positions, and a diverse group of liquidity providers.

But that comes with a caveat. There are important differences between futures and swaps markets, and recognising those differences is a policy goal. As a result, SEFs are designed to be "flexible".

"I hesitate to say that I want it to look like a futures exchange. There is some care given to recognising the distinction. Swap transactions tend to be much larger in size, but qualities of the contracts aren't really that different," Wetjen said.

Unlike the equities markets, futures exchanges have a far more simplified market structure, one which the regulator has a view into. All in all, it "would be quite manageable from a regulatory perspective (and) appealing to the market place", he said.

As SEFs develop, prop traders are taking an active role in voicing their opinions, encouraged by regulators like Wetjen signalling a welcome stance on their involvement.

Though the mood among prop traders towards trading on SEFs is positive, there are yet some issues to work out, said Sebastiaan Koeling, chief executive of Optiver US, a prop trading firm specialising in options. Koeling is also a member of the CFTC's market risk advisory committee in his role as a member of FIA PTG (Principal Traders Group), which represents some 20 prop trading firms.

Sebastiaan Koeling, CEO, Optiver US

Sebastiaan Koeling, CEO, Optiver US

Three years ago, the idea seemed like it was about fairness, increasing transparency and enhancing competition. But once some of the granular details started to come into play, like setting a mandated number of RFQs (request for quotes), it became a flag that perhaps not all participants were interested in being so competitive, said Koeling.

"I do believe the CFTC tried to get the path right in making sure that this is indeed becoming a bit more of an open and transparent market, but the rule making has been pretty hard to understand and interpret," he said.

One bone of contention has to do with swap dealer registration. There are exemptions for cleared trades, but what happens if a firm wants an uncleared swap? Does its floor trader exemption immediately fall apart? There is just no clear answer there, said Koeling. "Given the size of balance sheets that most of the prop trading firms have, it is not really an option compared to banks," he added.

Still, there are definitely market makers that want to provide liquidity in swaps. Some are waiting in the wings, even after Citadel became a prime mover by being the first and, at time of writing, only FIA PTG member active on SEFs.

The wait and see attitude has to do with another two linked issues: venues are bifurcated between dealer-to-dealer and dealer-to-customer markets; and there is a widespread practice of post-trade name give-up.

The practice of name disclosure started because of the need to mitigate counterparty risk in an uncleared environment, as well as record-keeping requirements. Now, however, swaps are cleared and it is not well understood why it continues.

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