The rise of the Electronic Communication Network (ECN) and Alternative Trading System (ATS) radically changed equities markets and exchanges in the 1990s, although many people interchanged the abbreviations to the point where often times what was technically an ATS got labeled as an ECN, and sometimes vice versa.
Financial reform has now given birth to a new three-letter entity, the SEF, which stands for Swap Execution Facilities and which could radically alter the derivatives market not to mention challenge exchanges. And just like an ATS probably didn’t necessarily appreciate being categorized as an ECN, those who see themselves as SEFs already are feeling misunderstood.
During the debate leading up to financial reform many a wise pundit pointed to the provision in the legislation that would bring dangerous derivatives out of the shadows and on to exchanges where the lights of transparency shine brightest, supposedly.
But it’s important to note that reform requires most swaps to trade either on an exchange or on an SEF. Not only should SEFs not be overlooked, they should be viewed as a key part of the equation as the swaps markets digest this brave new world.
GFI Group’s Chris Giancarlo, the interdealer broker’s executive V.P. in charge of corporate development, is also chairman of the 14-month-old Wholesale Market Brokers Association Americas (WMBAA), a trade organization that during the reform debate represented the interests of GFI, as well its rivalsâ€”ICAP, Tullet Prebon, Tradition and BGC Partnersâ€”all better known as IDBs but who stand poised to rise to the fore as SEFs.
Firstly, since SEF spells something closely resembling a word let’s go ahead and agree that we will not call these “ess ee effs,” and instead get our heads around the idea of referring to these entities, collectively, as “Sefs” (rhymes with refs).
Secondly, let’s establish a handy way of explaining what SEFs are. “Think of it as eBay for financial instruments that don’t trade on exchanges,” Giancarlo explained. “We already provide this service to the wholesale market.”
GFI is not officially registered as an SEF yet, and defining what constitutes an SEF, who gets to be a SEF, is something the Commodity Futures Trading Commission is going to have to figure out, but for all intents and purposes GFI and the other IDBs (or wholesale brokers) are already, what going forward will be, SEFs.
IDBs/wholesale brokers are best positioned to be SEFs because of their eBay platforms already in place.
(Quick sidebar from Giancarlo re the term IDB versus wholesale broker: “We have been called wholesale brokers for at least several decades since at least when we formed the Wholesale Market Brokers Association in London at the request of the Bank of England. IDB refers to that subset of the business of a wholesale broker that intermediates only among dealers, hence “interdealer” broker. Wholesale brokerage is where we serve not only dealers but also other large non-dealer counterparties, as we do in many markets, such as energy and equity derivatives.”)
Back to SEFs: Explain again why we need yet another three-letter financial services entity?
“The reform legislation was written to reflect the derivatives market as it existed,” Giancarlo said. “SEF is a new term, but not a new concept.”
What is a new concept is that swaps trades will have to, by law, be intermediated. Mandated intermediation means that OTC traders at a big bank can no longer call a client directly and sell them some merchandise; an exchange or SEF must be used. So while IDBs already serve as the eBay for OTC products, banks still have had the option of not selling something over eBay, so to speak, rather just directly to someone they know would be interested, just a two party, direct transaction.
“Think of it like this,” Giancarlo said. “You have a used car in your driveway. You could try to sell it on eBay and see who hits the offer. Or you could sell it your neighbor, or the guy down the street, without going to eBay.”
So now, by law, and sticking with this analogy, neighbors (traders) can no longer sell each other cars (derivatives); they need to use eBay (SEFs). Or trade on an exchange.
Because exchanges intermediate trades and have arms that clear trades, there was some concern that the SEFs would be at an unfair disadvantage because while they intermediate they don’t clear. And since the new law requires that derivatives trades, in addition to being intermediated, also be centrally cleared, SEFs could be shut out of the market in the event that clearing venues required or heavily incentivized buyers and sellers to use them for both intermediation and clearing, the so-called single silo model.
Lawmakers, recognizing that there are basically just a handful of exchanges in the world, and sensing that eventually there will probably one day just be one (called the NYSEEURONEXTLIFFECMEICE) went to the trouble of creating a playing field that did not discriminate against SEFs, requiring exchanges to provide SEFs with non discriminatory access to clearing services, hence fostering competition between exchanges like the CME and SEFs.
But GFI’s Giancarlo recognizes that SEFs are going to have a hard time competing with exchanges that transact and clear; it’s just a fact of life. That said, he is not discouraged because the things that GFI and rivals do in order to differentiate themselves in the IDB/wholesale broker market will help them in the new playing field.
“Depth of liquidity, product expertise, relationships, trust, knowing where to find the other sideâ€”these are all things that will make SEFs a viable alternative to exchanges,” Giancarlo said.
So the next time a pundit talks about how derivatives now have to trade on exchanges remember what they really mean is that they have to trade on exchanges, and SEFs, which are kind of like the same thing, only different. Like ECNs and ATSs. Sort of.