Execution

Swap Execution Facilities

A Swap execution facilities (SEFs) are electronic execution systems providing swap dealers anonymous execution capabilities. The trouble with SEF’s are their varied services, their connectivity and the current reliance upon on the buyer to setup Straight-Through Processing.

From early days some Swap Execution Facilities are beginning to win a high percentage of executing Interest Rate Swaps, Credit Default Swaps & Currencies.

With 18 approved SEF’s registered, it’s taken little time for the winners to become apparent.

Swaps Execution Facilities Must Meet Many requirements. Such as:

1. A SEF needs to provide Straight-Through Processing (STP) of all executed transactions. Meaning once a transaction is executed on a SEF, the trade is:
   1. Submitted for clearance to CCP
   2. Notification sent to executing firms AND their Middle office
   3. Provide connectivity to internal systems at executing firms so an executed transaction seamlessly connects with the internal systems of the executing firms.
2. The second “appreciable advantage” would be for a SEF to have Market Makers contributing swap prices.

With registration, the SEFs will be required to demonstrate continued compliance with all applicable provisions of the Commodity Exchange Act and CFTC regulations, including Part 37, and any future regulations, amendments, guidance, and interpretations issued by the CFTC.

CFTC staff is continuing with registration reviews for the remaining five SEFs that currently are temporarily registered. Pending their reviews, those facilities continue to operate under temporary registration status.

Source: https://sirt.cftc.gov/SIRT/SIRT.aspx?Topic=SwapExecutionFacilities

Expected Market Fragmentation Becomes Possible Concentration Risk

One of the problems with having many SEF’s is different firms will make different choices leaving the market fragmented.

Today fragmentation is much less of a problem, as the charts below show clear winners in each asset class. But in the absence of fragmentation, another risk shows its teeth:

ICAP is the clear choice for execution of Interest Rate Swaps while Bloomberg is the execution system of choice for Credit Default Swaps.

Currencies remains fairly well spread around the globe among various execution systems.

To see if one particular counterparty held a large amount of the outstanding swaps, or if one maturity held most of the market risk, we could do so by drilling down with the FIA reports.

Swap Execution Facilities – Statistics and Resources

Source: The Futures Industry Assocation (FIA) FIA TRACKER

Phone, Email & Instant Message

• SEF’s execute roughly 60% of Cleared Derivatives, the remaining 40% are executed by Phone, Email, Instant Message
• Uncleared (bilateral) contracts are almost exclusively transacted via phone, email or instant message. This is due to the time it takes to execute and agree to the economic terms of the contract

Front Office

Phone Execution

Transacting a swap contract by phone has its own trade process:

Pre-Trade

CVA (Credit Valuation Adjustment)

1. The salesperson models the swap in a networked system which feeds through to the credit department
2. The credit department analyzes the transaction and assigned an add-on, called the CVA or Credit Valuation Adjustment. It represents the funds the bank must add to the rate it receives (subtract from the rate it will pay) to cover the counterparty credit risk.
3. CVA Desks are a post-Dodd-Frank part of the process to centralize the amount of money a bank makes from a certain client or vice versa.

Post-Trade

1. The trade is agreed to by phone with immediate follow-up via email with the client
2. The client required to return the email signifying they agree with the economic terms of the transaction.
3. The transaction is then coded at the DESK LEVEL matching system. This will ensure the trader and salesperson agree on the terms of the transaction.
4. Once the trader approves the transaction has been submitted properly, it moves to the middle office for processing.

Middle Office

1. The middle office should receive all of the economic terms of the swap (i.e., we are paying fixed at X%, semi-annually & receiving 3 month LIBOR)
2. Middle Office prepares a template for ongoing calculation of accruals and the client’s “static data” by which the client is known:
   1. The client’s name and internal number
   2. An affiliation with a Parent client will be indicated in the type of number
   3. The reference number is given to the counterparties
3. The date of cash flow for each leg and the day count used to calculate each CF
4. This electronic message, for bilateral transactions, will include attachments with:
   1. The confirmation
   2. Transaction-related legal documentation
      1. If a contract is under ISDA Master Agreement, Give-up Agreement, etc.
   3. The amount of INITIAL MARGIN requested by tomorrow’s open of business
5. These documents will be sent to the counterparty for signing and returned.
6. Good practice includes converting all completely signed transaction into a pdf file. This way, all documents are in one location. Of course, there’s a copy sent to our disaster recovery site as well.

Email & Intranet Instant Message

1. Email transaction require the same process as phone post-trade.
2. Transactions Intranet Instant message is typically a company audit trail
3. This gives both parties a level of comfort but still require a complete set of documents
4. Both counterparties sign and file the final documentation.

Regardless of how a swap in executed, all economic information (not details relevant only to the counterparties) are submitted to the central repository.

Central Trade Repository For All Transaction – DTCC

All trades reported to a central repository are a big part of fulfilling the goals of Dodd-Frank. Knowing the volume of contracts traded can provide clues, but only by knowing the open contract (open interest in futures terms) can regulators monitor the systemic risk.

1. Trade reporting (Trade Repositories) create greater Trade Transparency by including both cleared and uncleared derivatives. Having a picture of the entire market, allows banks and regulators to monitor systemic risk in a particular product, maturity or asset class.
2. Systemic Risk transparency by having all swaps cleared through a central counterparty (CCP) gives the market a piece of information with regard to liquidity needs and concentration risk.
3. Transparency of market risk allows market participants and regulators to monitor and manage those risks.
4. There is no doubt that central clearing will allow institutions to show the market the risk that have today as well as systemic which may exist across the markets.

Websites

• Global Trade Repository (GTR)
• Markit
• Depository Trust Co (DTCC)
• ISDA – Swapsinfo – All Statistics