Prop shops to rival dealer market-makers on broker Sefs


Rules that require swap execution facilities (Sefs) to offer impartial access are set to bring years of over-the-counter market tradition to an end, by allowing hedge funds, proprietary traders and asset managers into the clubby, interdealer portion of the market.

A number of these firms are now in talks to join broker-run Sefs that are currently the preserve of incumbent dealers. The firms are attracted by the liquidity available on the exchange-like order books the platforms offer, and some plan to go toe-to-toe with the dealers as market-makers.

"We would all like to trade," says Chris Hehmeyer, chief executive of HTG Capital Partners in Chicago, which is a member of the 29-strong principal traders group (PTG), run by the Futures Industry Association. "We think we are capable – HTG and others like us, such as the firms in the PTG. Most of the firms are in wait-and-see mode, and that's where we are too. But we are very interested."

Fellow PTG members Tower Research Capital and KCG Holdings share those ambitions. "As our chief executive pointed out in our earnings call at the end of January, we intend to be trading interest rate swaps by the end of the year," says Isaac Chang, global head of fixed-income derivatives with KCG Holdings in New York, and former US head of electronic trading for rates products at Goldman Sachs.

In total, Risk spoke to nine firms that plan to quote prices on Sefs – a revolutionary move given that 80–90% of all swaps by notional volume currently have one of the 14 big dealers as a counterparty, and one that some dealers are said to be resisting.

We have intentions to be trading interest rate swaps by the end of the year

"In interest rate swaps, we have been given strong signals by our dealers that they would be annoyed if we, as a buy-side firm, showed up in the interdealer platforms," says one US-based hedge fund manager.

A trader at a second fund says the implied threats – to reduce or remove credit lines – are hard to ignore: "I have built relationships with my dealers through a request-driven, bilateral market where they know who they are trading with, and when I go to them they come through for me. If I am looking for large size, then they provide it at a good price; if I need to lay off illiquid risk, then they will help me do that. These are helpful services, and if they are withdrawn we would feel pain. If a lot of dealers withdraw, then we would feel a lot of pain."

Prop traders are rumoured to have been refused access to the interdealer portion of the over-the-counter market in the past, where market-makers are able to tap huge liquidity in support of their client business, with the big five brokers acting as facilitators.

The Sef rules have the potential to change that. Platforms that want to offer trading in the most liquid swap products will have to register as Sefs, subjecting them to impartial access provisions. This means all participants should be allowed to quote prices, as Gary Gensler, former chairman of the Commodity Futures Trading Commission, made clear last November before stepping down. Three proprietary traders and three hedge funds say they are currently in talks with broker-run Sefs.

The platforms seem to have no option but to let them in, but the head of e-commerce at one of these Sefs believes they will still remain the preserve of a small subset of firms – the dealers, with a sprinkling of prop traders and hedge funds, plus a few asset managers that need huge liquidity and are sophisticated enough to quote prices as well.

"We have spoken to firms that want to know how this will work. They want to know what the workload involved is and if it is worth their time," says the broker e-commerce head. "So, are we about to go from 50 clients to 5,000? No, we're not. There are things that certain buy-side firms need that aren't part of the DNA of an interdealer broker."

For their part, prop traders say the broker platforms are where they belong. Under CFTC rules, all Sefs will be required to offer an order book alongside the request-for-quote model that more closely resembles current OTC market practice – but in practice, market participants expect volumes on traditional dealer-to-client platforms like Bloomberg and Tradeweb's TWSef to go through on an RFQ basis almost exclusively, while the nominally interdealer platforms run by the brokers will be home to liquid order books.

"I have a lot of respect for the effort and infrastructure required by dealers to service institutional buy-side clients," says KCG's Chang. "It is unrealistic for me to expect to go there tomorrow. Instead, we can initially play a role where we are liquidity providers to liquidity providers. That is where we are targeting and where we will likely be this year. So, our focus will be on the anonymous order books and we'll see if the volumes justify us participating meaningfully there."


A feature on new swap liquidity providers appears in the March issue of Risk, and is available online here.

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