An Overview
Legislative bodies in the U.S. and Europe are moving to increase regulation of the over-the-counter (OTC) derivatives market. Pending legislation in the House and Senate seeks to memorialize the three key objectives for the OTC derivatives markets:
- Increase transparency
- Improve market efficiency
- Prevent market abuse
Many reforms are currently being debated, one of which concerns the creation and definition of a Swap Execution Facility (SEF) and its impact on how swaps trades are executed and cleared. The expected role of a SEF is to provide pre- and post-trade transparency, encourage competitive execution for the entire institutional marketplace, and provide the tools required to ensure a complete record and audit trail of trades. Depending on the outcome of legislation, there could be a significant shift in the way derivatives trading is ultimately executed, and Tradeweb has made great strides to be ahead of the curve for our clients.
Tradeweb is the leading provider of competitive electronic interest rate swap markets for the institutional marketplace. To date, more than $5 trillion has been traded by clients on Tradeweb, representing more than 55,000 trades.
How Derivatives are Currently Traded
Over-the-counter, or "privately negotiated", derivatives are currently traded on the telephone and increasingly on electronic markets, such as Tradeweb. There are two sectors of the market: institutional dealer-to-client (D2C) and inter-dealer (D2D). These markets are approximately the same size in terms of trading volumes, but there are many more participants in the D2C marketplace than D2D.
Multi-dealer, or competitive, electronic trading of interest rate and credit default, swaps began in 2005, when Tradeweb launched its U.S. dollar and Euro-denominated electronic platforms. D2C electronic trading is approaching 10% of the overall marketplace, and is growing fast.
Electronic trading offers the benefits that are being sought by legislators, including increased transparency, more competitive execution, efficient trade processing, and a complete and permanent audit trail.
Currently, all exchange-traded and some OTC-traded derivatives contracts are centrally cleared - the process in which financial transactions are cleared by a single (central) counterparty to reduce individual risk (see Figure 1). However, pending legislation could mandate central clearing for all standardized OTC swap contracts.
Figure 1: Central Clearing Process for OTC Derivatives
Central clearing of derivatives reduces counterparty risk and strengthens overall market integrity. It also helps with position segregation and portability in the event of a default, improves transparency for regulatory requirements and benefits the central management of trade lifecycle events, such as cash settlement with central counterparties and credit events in the Credit Default Swap (CDS) market. There are several select companies that provide derivative clearing services in the U.S. and Europe, and Tradeweb has taken steps to link its trade practices with those companies.
To further align with a regulatory shift and the needs of the marketplace, Tradeweb recently completed electronic links to the major derivatives clearing houses. This allows institutional clients to fully automate their workflow on Tradeweb- from trade execution through clearing (see Figure 2). Institutions are now able to better manage operational, systemic and market risk. To date, Tradeweb has integrated with ICE Trust and ICE Europe via ICE Link, and CME Clearing for the clearing of CDS.
Tradeweb has further developed connectivity to MarkitSERV, a global, electronic OTC derivatives trade processing company. Similar to CDS, clients are able to communicate through existing links to the platform's MarkitWire service for Interest Rate Swaps (IRS), for onward transmission to LCH.Clearnet's SwapClear facility.
Figure 2: Proposed Workflow, Fully-automated on Tradeweb
Next Steps
While most swaps have historically traded via phone, electronic trading is on the rise as market participants take advantage of the benefits of electronic trading. We expect that the industry will see an additional growth spurt in electronic trading and in the number of SEFs and exchanges serving this market.
Although no final legislation has been passed, the House and Senate will have active discussion in the conference process and some type of reform will likely be passed by early Q3 2010. Tradeweb plans to register as a SEF following the passage of a final Bill in accordance with the rulemaking that follows.