SEFs Control Their Own Fate – from the TABB GROUP

SEFs Control Their Own Fate
The SEF mandate threatens to reduce IDB swaps execution revenues by as much as 71%. But the fate of Swap Execution Facilities does not rest with the CFTC; those firms that can adapt their business models to the changing environment will emerge as heroes.
Despite the agonizing over the delayed rules, the fate of Swap Execution Facilities (SEFs) in fact does not rest with the CFTC; rather, it rests with the SEFs themselves.

TABB Group believes that the cost of interest rate swaps (IRSs) execution will dramatically decline as a result of the SEF mandate. In less positive terms, revenue associated with the execution of IRSs is going to collapse.

Interdealer-brokers have responded to the SEF mandate by lobbying to defend the industry status quo, in particular the “by any means of interstate commerce” trade provision. But with so many forces working collectively against the status quo – from regulation to technology – it is hard to see how the industry’s profitability can be maintained as a whole. TABB Group projects that IDB swaps execution revenues could decline anywhere between 43% and 71%, depending on the outcome of the voice-trading provision.

The reality is that declines won’t be as severe for those that learn to adapt their business models to the changing environment. The question is: Which of the SEFs will rise to the occasion and emerge heroic and victorious?

With the SEF mandate will come a range of impacts on the swaps market. These include:

Swaps market compression resulting from the cost of clearing
Bid/ask spread compression
Commission compression
Turnover velocity
Trade size reduction
Standardized terms for swaps
Changes to commission structure
Migration to futures

Together, these influences make up the writing on the wall: Transparent trading will lead to reduced execution costs. We have tried to imagine scenarios in which the opposite may be the case: Could an interdealer-broker expect to make more money as a SEF than it does today? The answer is, only if margins increase. And we find this hard to consider.

What if the swaps market expands so dramatically that volume offsets any negative compression in spreads? Indeed, this will have to be extremely dramatic. Both dealers and interdealer-brokers today enjoy such high margins from swaps trading that there would have to be a huge increase in turnover to balance the equation.

With the transparent trading mandate comes a push toward standardization. This will make electronic execution easier, eroding the ability of voice trading to compete. Also, with standardization, swaps start to look more like futures. This will accelerate the migration away from swaps and further reduce the overall swaps market size. As execution becomes less about relationships and the ability to show depth of market, and more about speed and price, SEFs will look less like brokers and more like technology companies.

Intuitively, we understand that predicting the demise of IDBs is a fool’s errand. They have proved to be resilient businesses in other challenging environments. Ultimately, however, we are going to see firms going at it alone in a strategic bid to win market share in the new trading world of SEFs. Visionaries that embrace the change will not only preserve swaps’ appeal against the futurization trend, they will gain market share in a broader liquidity pool. Given the right pricing model and the right combination of trade protocols, they are destined to win, even as others lose. These efficiencies may come in the form of lower commissions, sponsored-access models, maker-taker pricing, or all-you-can-eat caps on execution fees.

About carlarweir
I am a Cross Asset FIX Connectivity SME working for international banks. i also sit on the FIX Protocol Ltd Global Steering Committee, and am Co-Chair of the Global Cross Asset Committee. I also have a very strong background in Mobile Telephony, Cloud computing, SaaS, IaaS, PaaS, Big Data, innovation, and am a pioneer in Pseudolite technology.

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