OTC Derivatives Growing Pains

By Sol Steinberg, OTC Partners

Originally published on TABB Forum 

SEFs have introduced an entirely new workflow to the OTC trading environment, and it’s not without its issues. Growing pains must be addressed for this market to mature and grow. 

The swaps environment continues to undergo regulatory-induced reconstruction.  

The following selected items remain uncertain as the SEF market infrastructure takes form.

Blocks 

Block trades, which enjoy delayed reporting requirements and have capped notionals, provide a lesser degree of transparency around liquidity. Blocks are expected to be predominantly voice executed and can be done Off-SEF, but they still need to be reported to a SEF. 

Thresholds for blocks will increase this year, and levels in other markets such as exchanges may also be reviewed. Participants are not permitted to aggregate orders for the purpose of gaining block treatment.

Available Credit 

Regulation stipulates a clearing member must credit-check each transaction to ensure clearing certainty; however, Off-SEF workflows function with the FCM performing checks after the trade has been submitted to the DCO. This is an issue, especially for MAT instruments, which must trade On-SEF, and where the SEF has an obligation to pre-check credit. Fundamentally, the question comes down to “when is the trade executed?” – on the phone between counterparties, On-SEF, or at the DCO?

Multi-Leg Trades With at Least One MAT Instrument 

Package trades have a temporary reprieve from being executed On-SEF, given limit-checking capabilities are linear. While net risk can be small for a multi-leg trade, the trade risk can be sequenced such that a limit is breached. The solution is messaging capability to report packages as a single unit, as the FpML working group, SEFs, credit hubs and others are actively working on, with DCOs expected to support a standard by August.

Allocation: Pre vs. Post 

Allocations are another challenge, where the choice is between pre-trade allocation or using the bunched order option. Clients prefer pre-trade allocations, given that bunched orders require additional agreements with varying costs, are not available to all, and are short of controls to ensure the trade economics remain consistent. Pre-trade allocations, however, are not ideal given that the trade may not be completely filled or details on splitting are not known at the time of the trade.

Access Impacting Volumes? 

While impartial access to SEFs was addressed in November by the CFTC, activity to date has been concentrated among participants with direct access to the SEF. SEF volumes have been becoming concentrated among a few venues, particularly a couple of IDBs with the lion’s share of their business in spread trades for Interest Rate Swaps, and platforms with established desktop real estate in Credit Swaps. 

Volume is further impacted as dealers are trading less for their own book. Participants are flush with many portals to choose from, and with options for direct market access, agency trading or using broker systems to execute – activity is being rethought cautiously.

Important Upcoming Calendar Dates: 

• April 10:Blockhold threshold increases to 67%
• May 15:Package Trade reprieve expires
• June 30:Trade Submission reprieve expires