The Gateway to Algorithmic and Automated Trading

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.

Source: Aite Group

Source: Aite Group

One possible issue causing the hold-up might be to identify packaged trades - where the underlying and the swap are linked together - but Koeling is optimistic that a solution could be found without a need for post-trade name give up.

Notably, some SEFs, such as truEX and Javelin, do have anonymised trading but the traditional interdealer platforms tend to have most of the liquidity. Nevertheless, it seems likely that changing name give-up will need to be led by regulations and not by individual SEFs, Koeling said.

Bifurcation, meanwhile, makes market makers act only as a price taker instead of traditional roles as price makers, he explained.

"Why can't everyone trade on the same open transparent market? In Europe you can see there's still a concentration on single markets. In the US, it is happening on futures markets too. The more liquidity comes together in one place, the better chance there is to actually match customer to customer - which should be a good thing for customers. That is not really happening in the swaps world," Koeling said.

Getting CLOBered

The chance is there to really change things, said Michael O'Brien, director of Global Trading in Eaton Vance's global fixed income unit. The firm has just over $310 billion in AuM, and is active in both CDS and rates markets.

Michael O’Brien, Director of Global Trading, Global Fixed Income, Eaton Vance

Michael O'Brien, Director of Global Trading, Global Fixed Income, Eaton Vance

"We have the opportunity to do things like break down the dual structure market, where buy side traders can evolve into price makers and price takers, whether that is in a central limit order book, or any other trading mechanism that allows all-to-all trading," he said. "It gives more flexibility, more power to the buy side."

Because of global regulations like Basel III creating capital constraints on banks' balance sheets, moving to an all-to-all market takes some of the pressure off, O'Brien added.

"That is a scenario where everyone wins - this development of market structure. We invite in new liquidity providers, and there's a new role for the buy side. That is what excites me about SEFs," he said.

The reality is that nothing has actually changed. Instead, trading has become more expensive, O'Brien noted. Interest rate swaps and credit indices, which are under the Dodd-Frank trading mandate, were being executed electronically on what are now SEFs. O'Brien explained that the vast majority of his trades are done with three RFQs with the same liquidity providers - the big banks.

"It's the same thing I was doing except now I have to pay SEFs, middleware providers, building out new connections to all these platforms, compliance procedures. We've done all this work, and spent a whole bunch of money and to date, really nothing has changed," he said, adding that Citadel's entry into the market is a noteworthy exception and welcome development.

O'Brien is a strong and vocal supporter of trading through a central limit order book, but as of today he does not find enough liquidity in order to do more than just small trades.

"When I can get best execution in the order books, absolutely I will be there every single time. But if I have a large trade to do and the order book just isn't going to be sufficient, I am going to do what is in the best interest of our funds," he said.

At the same time, he is seeing a shift in mentality towards order books. Before, O'Brien is seeing a shift in mentality across the buy side towards order books. Before, he heard opposing voices express discomfort with disrupting established relationships or internal work flow. Now, there are more specific concerns such

as the issue of anonymity, connectivity, or average pricing (where a series of trades is allocated at an average price in anticipation of average ticket sizes getting smaller in an electronic market).

"They have concrete problems that can be solved. I am optimistic that order books will take off. The buy side doesn't do anything quickly because it is a fragmented, diverse group," he said.

Vendor views

The proliferation of SEF trading venues has caused a fair amount of speculation over which venues are likely to be the winners of a liquidity battle. Bloomberg and Tradeweb were considered the front runners, but a swathe of other entrants without brand name recognition also made a bid for market share.

That means platforms are required to get visibility into best prices across all the SEFs. UBS Neo is one example of a multi-asset platform used by the buy side to connect to multiple venues to do just that.

Steve Woodyatt, CEO, Object Trading

Steve Woodyatt, CEO, Object Trading

Steve Woodyatt, CEO of Object Trading, has seen an increasing level of prop trading interest in the SEF space, as well as opportunity for Object Trading's role as a single interface provider of global direct market access across asset classes.

"It is certainly our plan to be able to provide people with the connectivity they require to choose which platforms they can connect to. But the cost of this fragmentation is a big issue for the buy side," Woodyatt said.

Aside from compliance and technology costs, there are more than a dozen interfaces to develop to. That means direct relationships with each of the venues. The large buy side, like BlackRock and Vanguard, can afford a programme of supporting more than a few of these swap execution facilities, but other asset managers will be looking for a service solution, Woodyatt said.

Woodyatt's background includes a stint of systematic trading. He co-founded Object Trading out of frustration with multiple execution venues, non-real time prices, and a lack of risk platforms while having to deal with an explosion of trading venues.

"We can take a lot of the technology and connectivity pain away. What we can't do is impact the regulation where people are holding off on their decision to trade," he said.

The two basic matching functionalities in SEFs - CLOB and RFQ - vary greatly in their output. Woodyatt points to the CME's SEF as a representative example of CLOB, aka streaming, though the vast majority have both options - Bloomberg, Tradeweb, MarketAxess, Javelin, ICAP and ICE, for starters, all have CLOB capabilities but also employ RFQ and in some cases, voice dealing functions.

That means liquidity is fragmented across those platforms. Moreover, due to a tradition of relationship-based trading practices in the swaps market, the RFQ model dominates.

"There are limitations to the counterparties you can get quotes from in an RFQ model, and that changes from party to party," he said. "From an algo or systematic trading viewpoint, what you want is a time series price stream to be able to plug into your analytics to make a decision on when to enter or exit the market."

Meanwhile, in Europe, the emerging Organised Trading Facilities are currently being reviewed by regulators.

Whether OTFs and SEFs offer a direct comparison is still a matter of debate, but if the prop algo trading community is to get involved, streaming prices will be a necessity, Woodyatt pointed out.

"I wonder what sort of volume will be brought to bear, because maybe those existing SEFs that cater to RFQ models, and also subset of the existing proposed OTFs and the visiting approved SEFs as a venue (in Europe), will find benefit to relaxing that a bit," he said.

In Europe, Bloomberg seems to have chosen to set up a multi-lateral trading facility for interest rate swaps and credit derivatives. According to media reports citing unnamed sources, approval is in the final stages with the UK's regulatory authority, the FCA.

Mark Brennan, Head of Business Development, Americas, ITRS

Mark Brennan, Head of Business Development, Americas, ITRS

The industry's shift towards exchange- like models is ringing opportunity for a number of vendors looking to support automation of the market. ITRS Group, which works with exchanges and sell side, has been keen on assessing its offering from the perspective of data integration system monitoring.

"If you are a dealer, where you really are forced into a level of automation that you may not have had before, you need to look at your systems holistically, and you need to understand - where are my latencies and my quote responses?," said Mark Brennan, head of Business Development for the Americas at ITRS.

The challenges of watching the technology becomes obvious in the cash equities markets, which are still grappling with glitches both major and minor as electronic trading advances.

Now, as a dealer transacting on SEFs competing with other participants, being able to ensure systems are stable becomes increasingly important.

"It stands to reason that you should be very concerned about the latency of the orders that you are transacting, the prices that you might be streaming," he said. "There is not the liquidity that there is in cash equities or listed futures, swap transactions are generally big and so latency becomes a P&L issue."

"Understanding latency in terms of visibility scrutiny is critical," he added.

An alternative future

Even as SEFs wrestle for market share, other exchanges are launching a variety of swap futures contracts, including Eurex, CME, Eris and GMEX.

In a recent report, TABB Group said that an eventual rise in interest rates may serve as a catalyst for the next wave of conversion, as a rate hike and return of volatility will have new implications on capital resources for firms facing much higher Value at Risk (VaR) calculations.

TABB Group

Source: TABB Group

"This ultimately will result in higher costs for end users of traditional swap products, and with that, the appeal of listed alternatives will likely grow," wrote Colby Jenkins, TABB Group analyst.

When derivatives exchange start-up GMEX took a close look at the changing regulatory landscape, they felt that SEFs would lead to a saturated market likely to consolidate.

"There must be over 26 SEFs with licenses registered, taking interest rate swaps and basically automating what was a phone-traded manual process. It wasn't reinventing or innovating," said Hirander Misra, co-founder and chief executive of GMEX. "We saw this in equities markets in Europe and so with the SEFs there is bound to be some consolidation. Barring three or four of the SEFs which do IRS, most of the others have very little volume."

Where GMEX fits in, Misra's team decided, is in the 80% of the IRS volumes from firms looking to hedge and that have no need for physical delivery of the swap. But using existing futures contracts is a problem: they don't plug into trading or analytics models as they do not closely align to a swap, and lack granularity in the hedge, Misra explained.

Hedging a 30-year bond with a swap, for example, is expensive in terms of the cost of margin. GMEX decided to create a futures-like contract for OTC products that will also have centralised order execution, standardised central clearing and hedging of interest rate exposure. The contract is priced to an index based on tradable prices from the underlying swap market sourced from the SEF/MTF platforms run by Tradition and Tullet Prebon.

"In essence, you get a more granular hedge with our contracts but at the same time centralising liquidity on an order book compared to swap contracts," Misra said. "We build the index of those tradable swap places and the swap future that we have, and mark to market against those. That is how we make it relevant to the swap market."

GMEX has some solid backing. Virtu Financial is a client and Deutsche Boerse and Societe Generale are minority shareholders. Launch is scheduled during July 2015 with euro contracts traded first, and Sterling and USD as currencies expected to be rolled out over the year.

He projects that GMEX could pull some 1% of the interest rate swap market, assuming that about 10% of the swaps market will futurise over the initial six months, with steady growth thereafter.

"It is exponential given regulatory change coming in. The frontloading requirements come in for the buy side in September 2016, which means that they have to put up margin and centrally clear everything," Misra said. "This is going to play out over the next three or four years based on regulatory change in Europe."

Liquidity wanted

Jim Overdahl, partner at Delta Strategy Group, and an advisor to the FIA PTG, said that all swap market participants acknowledge that there is a need for new sources of liquidity and that prop trading firms would view SEFs as a natural extension of the role that they play on other exchange-traded, cleared markets.

Jim Overdahl, Partner, Delta Strategy Group

Jim Overdahl, Partner, Delta Strategy Group

But he also reiterates the challenges in getting margin efficiency across different products, and uncertainty in what the ultimate requirements are going to be.

Jim Overdahl, partner at Delta Strategy Group, and an advisor to the FIA PTG, said that all swap market participants acknowledge that there is a need for new sources of liquidity and that prop trading firms would view SEFs as a natural extension of the role that they play on other exchange-traded, cleared markets.

"They're optimistic but are looking for clarity in the rules on how member firms would participate," he said. "Part of the DNA as a trading firm is being able to manage their risk efficiently, and I think they look to trading across different asset classes for profit opportunities on individual venues, but they also look at how that trading can affect their risk management capability."

It is beneficial to diversify across different asset classes, he explained, as well as across new venues.

But SEFs are unlike every other cleared market. All the non-dealer volume, explained Graham Harper, partner at Delta Strategy Group, is occurring on a small handful of platforms on a disclosed,

non-anonymous basis with a traditional dealer bank, with Citadel being the exception to the rule. (Citadel declined a request for an interview).

Meanwhile, in a separate SEF market, there are dealers trading with each other laying off risk from the customer facing markets, either through brokers or in electronic order books.

"Liquidity providers really need to be in both markets, and given that one of them is very relationship driven, the barriers to entry are a bit different than in a futures- style set up," said Harper.

Some wrinkles are getting ironed out. Recently, the CFTC provided clarification on how to deal with a trade that did not clear for non-credit related reasons. "It's another effort by the CFTC to move the SEF markets forward, but there are other issues that firms have cited as problematic to market progression," Harper said.

Source: TABB Group

Source: TABB Group

The practice of post-trade name give-up is another issue that is under consideration with the CFTC.

"Market making firms who are providing liquidity do have concerns about the possibility that their trading strategies and positions might be revealed, and that is something they want to guard against," said Overdahl.

In terms of SEFs attracting new volumes to electronic order books, Overdahl said that setting aside the issues around access, like with any market, a crowd attracts a crowd.

"How do you get to that point where you have the critical mass that attracts volume? That's not really a regulatory issue, but it is part of how other markets have evolved," he said.

Hirander Misra, CEO, GMEX

Hirander Misra, CEO, GMEX


COMPARE - Hirander Misra

In Europe, the OTF regime still has to play out. If we launch other products, they could be MTF-like as well. It becomes a similar regime to the SEF/ECN regime in the US in many ways. There are some differences, but in terms of construct we are not a million miles away between the two.There are similarities - centralising liquidity and electronic execution with an element of RFQs and discretion. On an OTF you will be able to trade OTC products as well as exchange-like products. Whereas in the US, you have got SEFs that trade effectively OTC products or OTC-like swaps and CDS. The direct contract market, which is more like an MTF, is for exchange-like products.

CONTRAST - Christian Voigt

Christian Voigt, Senior Regulatory Adviser, Fidessa

Christian Voigt, Senior Regulatory Adviser, Fidessa

SEFs and OTFs are completely different things. They really are two different kinds of animals. For one, the US is much further ahead with Dodd-Frank than Europe is with EMIR. Europe has barely got to mandatory clearing let alone the mandatory trading bit.

If you look at the current status in the US, you will see there is a strong tilt towards the agency model. The SEF becomes more like an electronic market we know from other asset classes.

If you compare an OTF to an MTF, the one unique feature that drives everything else is that an OTF is discretionary. I have discretion about which order I am going to match. An OTF puts a legal wrapper around the existing dealer platforms that are operating today.