Swap Execution Facilities (SEFs): Everything Old is New Again
SEF fanfare not warranted
In the US, Swap Execution Facilities (SEFs) or SEFs are registering with authorities at a rapid clip. SEFs appear shiny and new and market commentators and the press report each new SEF registration with great fanfare. However, I believe SEFs are not really that new.
Moreover, for observers in the exchange space, SEFs may seem to be organized and operate similarly to exchanges. In fact, some SEFs also have licenses which allow them to operate essentially as exchanges. In some cases, they have even been referred to as exchanges. However, all SEFs cannot be called exchanges and some will operate very differently than exchanges going forward.
SEFs are not really new
This is not an article on legal structure of SEFs because many man hours have been spent covering the evolution of Title VII of Dodd-Frank in the US and the numerous revisions and guidance from US regulators, such as the United States Securities & Exchange Commission and the Commodity and Futures Trading Commission (CFTC). Rather, this is a note on some observations that many people miss or else de-emphasize in the market which need to be emphasized.
First and foremost, too many observers conclude that SEFs are new. While they may be new legal entities, the technology, people and other operational infrastructure supporting the SEF are not new, they are just enhanced.
In other words, while the SEF is new, the platform is really not. For example, while both ICAP and GFI intend to become fully fledged SEFs, they already had most of the capabilities from a technology standpoint so they needed to only “copy, paste” the know-how and technology into the new entity and make sure it conformed to the evolving CFTC and SEC rules.
Similarly, the multi-dealer platforms have been building technology supporting trading of OTC derivatives for quite a while, so they are not new players at the table. Everyone recognizes them and their technology. Their platforms were essentially the shadow SEFs already in the market, and what was top of mind for them was really enhancements to existing trading protocols based on what protocols would ultimately be allowed on these platforms.
SEFs were fairly predictable
In a larger sense, the SEFs that we observe registering, barring few exceptions, were predictable (at least to us) because they are the same players in the wholesale brokerage markets with the most to gain and lose. For example, we can see now the actual registrants consist of the primary wholesale brokers (interdealer brokerage is another term used but one that makes less sense every day) such as ICAP, GFI, Tullett, Tradition, and BGC along with the multi-dealer platforms Bloomberg, Tradeweb, and MarketAxess. No surprises there. While there are some exceptions, the existing players overwhelm the new ones.
SEFs will consolidate and concentrate
Our view was always that a number of incumbent platforms would register as SEFs as soon as possible, with high concentration around credit default swaps (CDS), interest rate swaps (IRS) and also foreign exchange (FX) swaps. In addition, a few newer, challenger firms would announce their registrations as we have seen with Javelin and trueEX. This has largely played out, with fewer actual registrants the longer that Title VII and specific guidance from the CFTC was delayed and as energy and resources were spent planning for and awaiting the final rules.
Our other view was that some would not be as successful as others and right now with the data we have it is far too early to tell, but we believe that this will largely play out. Success factors will include connectivity and clearing, technology, specific trading protocols, other trading functionality and of course the almighty liquidity which is why traders will seek out SEFs anyhow.
Finally, what we also believe is that SEFs will concentrate and that ultimately, because of network effects and the need to refresh technology budgets annually, among other expenditures, we will see one to two SEFs get the majority of market share per asset class (by asset class we mean rates, credit, equity and FX). This may take much longer to play out but we believe concentration will be the rule, not the exception over time. Scale will win out.
SEFS are not really exchanges
Moving on to the next key point, one reason SEFs cannot be called exchanges is because they offer order types which we equate to voice and OTC markets, such as request for quote. Today, SEFs can allow for RFQ alongside central limit order book functionality, making SEFs hybrid trading models. The diversified trading models can be at the SEF level through multiple trading protocols or at the firm level, by diversifying the type of registration.
However, there are exceptions that make this conclusion muddier. For example, one particular platform, trueEX, while already a Designated Contract Market (DCM) for futures and swaps, essentially an exchange, decided to also register as a SEF to be offer highly customized RFQ on the platform in addition to other capabilities. It was not lost on trueEX that an exchange order book model might not be appropriate for all instruments and segments of the swaps marketplace (in this case, interest rate swaps). Thus, while trueEx will be a SEF as well as a DCM, the SEF will operate very differently than what we would normally think about an exchange due to the existence of RFQ, which cannot be located at the DCM.
Another reason that SEFs are not really similar to exchanges is the decoupling of execution and clearing. While not all asset classes trade and clear on the same platform with the same entity, many do around the globe, so SEFs are really a different breed because they will never really clear these products. Clearing is separate than trading, with the SEFs connecting to the clearinghouses (CME, ICE, LCH) rather than running a clearinghouse themselves. While the existence of clearing alongside trading is not a universal definition of an exchange, it does show the differences between SEFs and exchanges with clearing organizations.
Which brings us to another glossed over point in the SEF market, which is that this was always really about clearing and less so about trading.
Clearing is the thing
Shakespeare said “the play is the thing”. In swaps market, clearing is the thing. Electronic trading, while important, has always been secondary to clearing. Exchanges, particularly those with vertical clearing models, would thus not recognize SEFs as their exchange brethren.
Nonetheless, even if you agree that SEFs are not really new, in electronic trading SEFs have the opportunity to drastically reshape trading. They will also support clearing by connecting to the clearing houses.
However, because the vast majority of SEFs have their technology and operational roots in the wholesale brokerage markets or as multi-dealer platforms, let’s just not call them brand new. Some may achieve great things, but they will do it by sticking to their roots, not by abandoning them.
About David Easthope
David Easthope is a research director in Celent's Securities & Investments group and is based in the firm's San Francisco office. Mr. Easthope's expertise lies in electronic trading, market venues, and market structure.
Mr. Easthope's research focuses on themes of strategic importance in the capital markets sector, including the evolution of market structure, the development of advanced and algorithmic trading, and innovations in both software and services. His recent consulting work involves advising clients on developing advanced trading platforms and new market venues. He has also advised strategic and private equity investors on innovation and trends to help them make more informed investment decisions in the capital markets arena.
Mr. Easthope has been widely referenced in the press, including Bloomberg, Financial Times, and CNBC.
Before re-joining Celent, Mr. Easthope was a director of strategy at Charles Schwab. Prior to this role, he held positions at Celent as an analyst and at brokerage firm Detwiler Fenton as a business strategist. He has also held equity research roles at Raymond James & Associates and Friedman, Billings, Ramsey covering companies in the financial technology industry.
Mr. Easthope received his BA and MBA from Vanderbilt University. He is also a Chartered Financial Analyst and a member of the CFA Society of San Francisco.