SD- Especially in the OTC markets, there is a lot of sensitivity around what is a proprietary advantage and what isn’t. Transparency is typically less and initially a lot of what we did was to make the community comfortable that actually connectivity should be seen as an overall advantage for everybody and it made sense to drive down costs to add benefits to everyone, while competition and innovation could occur on top of that.
That was where we started, and once there was a general acceptance that it all made sense, we then kicked off a series of working groups. The dominant actors were the SEFs and also the sell-side, however there was representation from the buy-side and from software vendors to look to creating a sort of a SEF API.
In terms of different regulation, is your protocol scalable?
SD- We did it in a way that can have a global applicability. For example, MiFid 2 in Europe is a few years behind Dodd-Frank, but it’s coming along and since its principles are very similar to Dodd-Frank, we were looking to make sure that the solution is easy to port across to other global markets. Currently the SEF API has been adopted by pretty much everyone, which is quite an achievement.
Rumor has it, that trading volumes on the OTC markets have been largely restored. How has the expected liquidity challenges been addressed?
SD- When SEFs first went live there was a drop in liquidity, as everybody started to get accustomed to the new trading paradigm. Now most people are comfortable to trade and there is a lot more comfort also about what should be traded on SEF and what can be traded off SEF. Today package transactions such as switch or spread products for example, are outside of the scope of the CFTC mandate. They are coming into scope by November so there are other types of swaps that are starting to be on-boarded, but everybody now is certainly more comfortable as to which trading paradigms should be on SEF and which off SEF and how that works. It took a while for that to settle down since there are a lot of moving parts.
One of the key design considerations for the new swap execution facilities was to make sure that any trade that occurs is going to be cleared to remove the bilateral counterpart risk, but the CFTC wanted to make sure that there was a guarantee at the pre trade level that if the trade does occur, i.e. if the SEF says – done, and the trade message is generated that there would be confidence that it would go all the way into the clearing house and be accepted.
So what does that mean – the key takeaway is that there are additional workflows at a pre-trade level to check whether there is enough margin in the clearing house to guarantee that this trade is going to succeed and would not be bounced because of lack of margin. Some of the workflows that historically have been seen as a post-trade workflow (will this trade actually clear in the clearing house) have been brought into the pre-trade space. During the pre-trade negotiation of an order, the SEF has to validate that it will clear further down the line if a trade is done.
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There are lots of moving parts and lots of different types of entities have to be invoked – the futures commission merchants, the CCPs, the SEFs, the executing broker, the clearing broker, etc. So it did take some time for the whole system to settle down and everybody to be comfortable that volumes could be pushed through the system and it will work properly.
What are the main issues now?
SD- The big issues now are related to the various jurisdictions – for example, how does a European entity access US liquidity? etc. The key point is to establish a global market place. Given where we are with different regulations, there has been fragmentation of liquidity, so going forward we have to try and minimize the danger, which this fragmentation brings across jurisdictions.
How has the FIX protocol helped address that?
SD- If we look at a regional level, actually the challenges associated with internal fragmentation have been significantly mitigated by the use of FIX. It’s very easy now for both the buy-side and the sell-side to deploy their technology for different asset classes through the use of aggregation tools or smart order routing to effectively rebuild and reintegrate that market, even if there are individual liquidity pools in different SEFs. We’ve done a pretty good job within each regulatory environment, maximizing the integration and making sure that internal fragmentation can be re-aggregated very easily through cross asset technologies that exist today.
Would you say that eventually we would get regulators across the world to cooperate and establish a global OTC derivatives market?
SD- It’s much better to ask a regulatory body, but from a practical perspective I am relatively positive on this matter. At a detail level from our conversations with regulators in Europe, what we see is a willingness to work with the industry to make sure that as far as possible the European regulators learn their lessons from the US. While it doesn’t mean that they are going to do things in exactly the same way, it does show that there is a willingness to understand what the US has done. Looking further ahead at Asia, those regulators are observing what’s happening with both Dodd-Frank and MiFid. Overall, it looks like a lot of good interaction is starting to happen at the grassroots.
So, how have the SEFs implemented the FIX Protocol?
TH- We have defined a set of specifications that any API needs to conform to – about 80 different workflows within the SEF concert. Our job was to set the standard, which allows each SEF to implement something and then all the interested parties to be able to code up to that standard, and feel comfortable that if they did it for one SEF, that implementation could be leveraged for the other SEFs as well. We deliberately wanted to stay away from building a network ourselves, so the specification allows interested parties to build their own technology in an open world. Our specification is an open standard.