Swaps market structure changes create fragility

New regulations pushing execution in the US$630trn over-the-counter derivatives market onto electronic platforms may be contributing to a more fragile trading environment and exacerbating shocks, market participants have warned.

“We’re seeing a fragility of markets that hasn’t existed before and we can see that in the rise of flash crashes and big market moves,” Dexter Senft, managing director for fixed income e-markets at Morgan Stanley, told Isda’s European conference in London this week.

New rules under Dodd Frank require all US standardised OTC derivatives to be traded over regulated swap execution facilities. Similar rules to be launched under MiFID II in 2017 will push Europe’s swap market further down the electronic route, where trades will be subject to greater pre- and post-trade transparency.

“The nature of swap markets is as they become more transparent, they tend to have less depth. We’ve seen fantastic ability for markets to execute small size, but large orders can’t be executed all at once,” said Senft. “Quants have long term careers once again figuring out how to get their trades done in small parts.”

For corporate end-users looking to hedge business risks, the combined effect of new rules is creating an uphill struggle. New capital and leverage rules have triggered widespread dealer pull back from balance sheet intensive fixed income and swaps businesses, while a fractured approach to rule making has caused swap market liquidity to fragment along geographic lines.

“We’re exempt from clearing but our dealer counterparties are not, so it becomes less feasible to enter certain types of swaps. We understand that many end users aren’t hedging as a result,” said Renuka Gupta, associate general counsel for derivatives and reform implementation at General Electric.

“There are now very few dealer firms out there that we can really rely on other than banks where we have strong touch-points. Typically the main reason banks continue to offer services is if they have underwritten debt.”

Flexible execution

So far, the CFTC has stopped short of calling for swaps to be traded on electronic order books akin to equity market protocols and dealers have railed against such extreme action, arguing that trading on central limit order books is not suited to all markets.

“We need to ensure there is sufficient flexibility of trading mechanisms as setting the rules to force one type of execution just doesn’t work,” said Laurent Paulhac, CEO of Icap SEF.

“In electronic trading, market participants can get hurt very quickly, especially if they are in a central limit order book. In times of stress you need to be able to put buyers and sellers together.”

Some believe that widespread electronification may have contributed to the Swiss franc rout earlier this year, when the currency’s de-pegging wreaked havoc across the FX market.

“Typically you’d see a 25% adjustment and choppy trading, but for eight and a half minutes there were no bids and offers on any screens,” said MS’s Senft.

Others note that it is almost impossible to draw parallels between equity market structures and other asset classes. For example, of more than 6,000 listed NYSE equities, most trade tens of thousands of times a day and even the most illiquid names change trade 100 to 200 times daily.

“That’s as much as the most active corporate bonds,” notes Senft. “Fixed income securities just aren’t suitable to trade on CLOB as it’s too risky to be a price maker”

Citadel opens the door

While brokers and dealers cling tightly to their precious RFQ model amid fears of any regulatory attempt to force a shift to CLOBs, there is some evidence to suggest a tentative and voluntary move towards order book execution.

Icap’s Paulhac notes that the majority of the broker’s SEF execution business comes under the voice RFQ protocol, but that is beginning to change. In the last 18 months the firm has noted a behaviour change with traders putting liquidity directly onto electronic screens. Electronic execution now accounts for 22% of the broker’s notional SEF trading activity compared to just 15% six months ago.

“There’s a willingness from market participants and new entrants to use our SEF and many are willing to put orders at risk on a CLOB,” he said. “The interplay between voice and electronic trading is working well and has been quite successful.”

One of those embracing the electronic model is buyside firm Citadel, which is now a top-five market maker for US interest rate swaps on the Bloomberg platform and is set to replicate that success in Europe.

“It’s very clear that there’s a lot of pressure on traditional liquidity providers that has caused them to pull back. We need to make sure that those that can fill that liquidity gap are able to do so” said Paul Hamill, global head of institutional securities at Citadel Securities.

The firm streams executable prices to trading screens at tighter levels than most competitors. However, Hamill notes that many larger clients find that even the most aggressive CLOB prices, don’t compete with their RFQ expectations.

“The question is who is going to put up super-tight orderbook levels that stop clients using the RFQ model,” said Hamill. “We think that the transition will be much slower and we’ll probably see more development of the RFQ model. It seems to me that it’s not certain that we’ll move to CLOBs.”

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