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  • Nov 25, 2011 | emarkets

    The Role of a Swap Execution Facility (SEF)

    Click here for a similar blog posted March 2014: SEF 101 - Understanding the Role of a Swap Execution Facility (SEF) 

    Tradeweb - Prepared for Market Reform

    An Overview

    Legislative bodies in the U.S. and Europe are moving to increase regulation of the over-the-counter (OTC) derivatives market. These global financial reform initiatives seek to achieve three key objectives for the OTC derivatives markets:

    • Increase transparency
    • Improve market efficiency
    • Reduce systemic risk

    Many reforms continue to be 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 in the U.S. The Dodd-Frank Act lays the foundation, defining a SEF to be "a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce."

    The expected role of a SEF is to provide pre- and post-trade transparency, encourage competitive execution and provide the tools required to ensure a complete record and audit trail of trades. 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 $9 trillion has been traded by clients on Tradeweb, representing more than 100,000 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 more than 10% of the overall marketplace, and is growing fast.

    Electronic trading offers the benefits that are being sought by legislators and regulators, 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, Dodd-Frank and the rules promulgated from Dodd-Frank will mandate central clearing for certain types of swaps.

     Figure 1: Central Clearing Process for OTC Derivatives  

     The Role of a SEF_chart 1 

    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.

    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 IDCG, ICE Trust and ICE Europe via ICE Link, and CME Clearing for the clearing of CDS and CME and LCH for IRS.

    Tradeweb has further developed connectivity to MarkitSERV, a global, electronic OTC derivatives trade processing provider. 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   

    The Role of a Swap Execution Facility 


    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.

    With the passage of the Dodd-Frank Act, the lawmaking phase is in the hands of the CFTC and the SEC - a process that may continue to take some time to be completed.
    Tradeweb is actively involved in ongoing discussions with regulators, and is diligently moving forward with the necessary steps to register as a Swap Execution Facility in the U.S., while continuing to operate as a Multilateral Trading Facility in Europe. 



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