Both Dodd-Frank and MiFID 2 make it clear that single dealer platforms do not qualify as a Swap Execution Facility (SEF) or organised trading facility. Therefore, the execution of derivatives products identified in legislation that have been traded on these platforms would move to an exchange or other venue.
They would have to qualify in the US as a SEF or under MIFID as a Multilateral Trading Facility (MTF) or organised trading facility. Banks would thus lose the deal flow and execution revenue for those products that qualify for central clearing.
The logical consequence for the banks is to adopt an agency trading model where they aggregate liquidity across SEFs or organised trading facilities and route client orders to the appropriate venue for execution. A number of banks have already announced that they are considering becoming aggregators of SEF liquidity.
Whilst there are a number of hurdles to overcome, the primary one being that the SEF rules themselves are emerging, there are a number of things a bank can do now to prepare to become a SEF aggregator:
1) Overcome internal product silos to be able to value and margin swaps across asset classes. In the new world, swaps will be executed on different venues and parties to the deal will have a choice of central counterparties to use. A bank offering aggregation would benefit from providing clearing services as well. Thus they would need to be able to value and margin products across asset classes for the same client, as those clients may elect to have the same central counterparty.
2) Perform a cost and capacity analysis of the swaps post trade infrastructure. When developing a commercial model for this new agency business, it will be critical for the bank to understand how many transactions it can process and the cost of processing these transactions. This will determine whether offering an aggregation service will make economic sense for the bank. In some cases, capacity may need to be enhanced involving not only system changes but removing any headcount to volume dependencies in the process flow.
3) Investigate the adaptability of existing smart order routers for swaps. If an aggregation services is to be offered, banks will need to be able to route orders to the most appropriate venue for “best execution.” Existing platforms for order routing should be able to handle the different product types. They will also need to be able to cope with the request for quote method of trading; even where products are traded using the order book method, for certain deal sizes, request for quote may be more appropriate.
4) Participate in industry initiatives on connectivity. Whilst there may ultimately be third party vendor products that will facilitate connectivity to various SEFS, banks should participate in industry initiatives to agree future connectivity standards such as the FIX initiatives for fixed income. This will provide a greater chance of influencing the outcomes and having the information and vendor exposure to be ready to connect to different SEFs.
5) Build an organisation within the Prime Services business that will own this new agency business. Essentially, there needs to be Chinese walls separating them from existing Swap trading businesses. This organisation should be responsible for tracking the relevant regulations and ensuring that client agreements can be set-up to facilitate the new business.
Whilst there is still uncertainty regarding SEF rules and the practicalities of SEF aggregation, banks may be reluctant to make concrete investments in systems or products. However, the five recommendations will position any bank as one of the first players in providing such a service irrespective of the outcome of the detailed rule making process.
Kenan Maciel is Director of Lab49’s strategy group. For more information, visit www.lab49.com.