Everyone Wants to Start An SEF

One of the arcane terms to come out of the Dodd-Frank financial overhaul is the ‘swap execution facility,’ which has the potential to create a boom in electronic trading platforms for OTC derivatives.

But exactly what is the definition of an SEF? According to Kevin McPartland, senior analyst at Tabb Group in a video interview with Advanced Trading, that question is still up for debate. The language in the Dodd-Frank legislation is vague and it’s up to the regulators—mainly the Commodity Futures Trading Commission— to refine the definition.

Regulators at the CFTC and Securities and Exchange Commission are drafting the rules that will define what is a major swap participant and what is a SEF. (Rules will be posted by Dec. 9th for comment, and final rules are due by July 15th). “It’s similar to an ECN for the swaps market,” explained McPartland, who said, we should think about SEFs “as price discovery platforms where you can execute and can have more transparency.”

While the legislation talks about trading OTC derivatives on exchanges or electronic platforms, it’s not clear which instruments are to be listed on SEFs versus exchanges. There are also concerns about what type of trading model will be acceptable to regulators. For instance, there are many dealers that run single-dealer platforms, where multiple customers interact with a single dealer. Regulators are said to frown on this type of trading model. Dodd-Frank specifically mentions many-to-many relationships — the idea that many customers should interact with multiple dealers.

In a recent interview with the Financial Times, CFTC Chairman Gary Gensler, noted Congress has said the new trading platforms “have to be open to multiple parties and that multiple parties have to take bids an offers.” Gensler also said there has to be “impartial access.”

Meanwhile, dealers that operate voice brokerage or hybrid trading platforms are worried about how their liquidity will be transferred to the new SEF screen-based environment. But one executive with a major dealer told me recently that the Dodd-Frank law mentions that trading can take place through any form of interstate commerce, which implies that phone and voice brokerage could be acceptable.

But despite the uncertainty over the final rules, many existing players and newcomers are positioning themselves to become SEFs. Among the existing players, interdealer brokers (IDBs) are in a good starting position, says McPartland. “So much of the activity is in the dealer-to- dealer market, and these IDBs handle that flow already. What these rules will do is formalize the roles of SEFs as the intermediary… It will require the flow to go trough these SEFs so the IDBs will get even greater volume,” said the analyst.

But McPartland said there will be room for many participants. Existing platforms such as MarketAxess, Tradeweb and Bloomberg have said they would qualify as SEFs, while exchanges like ICE, CME, Nasdaq and NYSE Liffe, as well as the newer ELX Futures Exchange, are also candidates for launching SEFs. Start ups like Eris Exchange, an independent platform backed by a handful of high frequency trading firms, and Javelin Capital, will drive competition with new technology, he said. McPartland noted that Gensler said he expects 30-to-40 SEFs to register right out of the gate, though McPartland estimates the number is closer to 20 or 30, because there could be some “quick fall out due to mergers and acquisitions and some fallout."

Certain SEFs could specialize in different products and customer segments. There could be SEFs that specialize in credit, rates commodities, FX, or equities and still be a place for dealer-to-dealer trading, dealer-to-customer trading and perhaps dealer-to-smaller customer trading.

With the potential for SEF proliferation, one worry is that regulators will create a fragmented market similar to the way that Reg NMS paved the way for fragmentation in U.S. equities. Pointing to the Flash Crash of May 6th in US equities, swaps participants are wary of the unintended consequences that can result from regulatory overhaul. They look upon the fragmentation in US equities as a disaster, which they’d like to avoid in swaps. But in such a complex market with multiple levels participants, this will be challenging.

While the rules for SEFs are still up in the air, there is a great deal of optimism that SEFs pose a new opportunity for Wall Street. Though the SEFs will lead to narrower spreads and profits, they will bring higher trading volumes and real-time pricing streams in the most liquid swaps should come out of these platforms. Some day E*Trade and Ameritrade could be routing retail orders to an SEF to buy credit default swaps on GM stock. Stay tuned for more clarity on the evolving world of SEFs.