SEF Volumes Will Rise, But Long-Term Pessimism Persists

By Colby Jenkins, TABB Group

Originally published on TABB Forum 

SEFs went live last October, and swaps trading hasn’t been the same since. After months of speculation and anxiety, the initial round of Made-Available-to-Trade (MAT) determinations came into effect in February, and for certain swap contracts, SEF trading stopped being an option and became a legal obligation. These mandates have been a catalyst for growth in the SEF market, and six months later we are starting to see certain SEFs breaking away from the pack, although discontent still remains high among participants.

Market participants aren’t completely sold on the new regime. Despite a steady rise in volumes since optional trading first began in October last year, two-thirds of respondents to a TABB Group study expressed that they are more willing to do more business via swap alternatives such as swaps futures as a direct result of SEF rule implementation (see Exhibit 1, below). In addition, a series of customer-facing SEFs allowing both electronic request for quote (RFQ) and order book trading have come on-line, and they are gradually gaining market share, as TABB predicted at the start of this year. Voice RFQ, which closely aligns with pre-existing swaps workflow, was allowed for in the final SEF rules published last year. 

Exhibit 1: Now that SEF rules are implemented, are you more inclined to do business via swap alternatives? 

Source: TABB Group 

In terms of overall market share, the prevailing execution protocol remains dealer-driven RFQ. The issue from the beginning has been whether these interdealer SEFs could attract buy-side flow as MAT mandates forced swap participants onto SEF platforms. What we have seen since these mandates came into effect in February is a steady migration of notional volume onto newer dealer-to-client (D2C) SEFs, which offer more standardized, exchange-like protocols. While these client-facing SEFs may have captured less than 8% of notional flow for rates in the first few months, today that figure is upward of 35%. This flow also indicates an appetite for less traditional swaps trading protocols, such as electronic RFQ and Central Limit Order Books (CLOBs), reflective of the fact that survey participants anticipated that by 2015, 40% of the market will be traded via electronic RFQ, 31% via CLOB, and less than 25% via voice RFQ.

Nevertheless, it must be said that volumes across the board haven’t exactly been up to expectation so far. Of the 135 participants surveyed in TABB’s SEF Industry Barometer 2014, more than half felt that the notional size of the swap market would shrink within the next few years. Meanwhile, the reason behind less-than-stellar SEF volumes to date was not unanimous among survey participants: 61% believed that more non-standardized swaps were being utilized as a means to bypass execution mandates and remain off-SEF, and 45% believed swaps users had forgone previous levels of trading due to the cumbersome economics of clearing and SEF trading (Exhibit 2).

Exhibit 2: Where Has SEF Volume Gone? 

Source: TABB Group 

The last TABB Group SEF Industry Barometer, published in July 2013, outlined the implications of newly finalized SEF rules and the Industry’s vision for the future of SEF trading and the OTC market as a whole. Our 2011 report focused on the industry’s stance on some initial key issues that still are being debated today. This is TABB Group's fourth SEF Industry Barometer and we have incorporated the relevant results from each study to show the steady increase of pessimism about the prospect for future growth.

But there have been positive surprises. The emergence of SEF aggregation and intermediation may help reduce initial barriers to entry, and the limited MAT self-certifications have helped increase certainty. International regulatory cooperation may help bring some market participants back to the table. On-SEF trading can only grow in importance, but the market still looks very crowded. The expansion of alternative trading protocols and a wider array of SEFs truly challenging for market share is an important first step on the road to a functioning market.