By forcing certain swaps trading onto
SEFs, Dodd-Frank is asking the swaps market to make overnight
changes that took the equities market 20 years. This means more
risk from more directions, and Mark Brennan of ITRS Group
argues that rigorous monitoring is essential to ensure the
new empire doesn’t crumble at the start.
The new swaps market structure, driven in the U.S. by
Dodd-Frank, is unprecedented in its disruption to market
participants, and has inspired no shortage of debates and
jeremiads on its various flaws and shortcomings.
That’s understandable: by regulatory fiat,
almost overnight, swaps trading has had to move to an
electronic market – a move that most other markets,
notably cash equities, but also exchange traded derivatives,
FX, and corporate credit, have been making at varying rates for
Whilst they’ve had the luxury of adding and
altering systems as and when the rules and markets change,
growing organically and ironing out kinks along the way, the
swaps market has been granted no such luxury.
Sure, there may be some second-mover advantages –
lessons learned from mistakes already made – but the
swaps market is being asked to build Rome in a day, with all
the difficulties that entails.
The new SEF trading mandate has imposed significant
regulatory hurdles for banks, and caused them to re-assess
entire business models.
But above all else, SEF trading imposes technological
problems – across a variety of functions and
Banks must connect to SEFs, get market data, apply credit
checks, execute trades, connect to an SDR (if a dealer), and
connect to the clearinghouse.
Although these core technology problems are fundamental to
regulatory compliance and running a rates business, another
set of problems pervades: how do you understand and
monitor the complex technology infrastructure needed for SEF
A second-order problem brought to the fore
The evolution of the cash equity markets in the late 90s and
early 00s involved a steady march towards automation.
More and more trading was done electronically; more
servers were used to run complex trading environments, which
sometimes replaced entire trading desks.
As infrastructure grew, and trading volumes increased, banks
saw increased instability, resulting in large-scale, firm-wide
initiatives to create technology systems and teams devoted to
operating and monitoring their trading infrastructure.
It took a number of years for this "second-order" problem to
succeed the core problem of building technology infrastructure
to address client and market structure requirements.
Put differently, it took several years before
banks’ business interests aligned in such a way
that key stakeholders understood they needed to monitor their
trading plant, not only for stability and capacity, but also
for visibility into fault tolerance, as well as client
Now, however, technology was the main driver of trading.
A new requirement to monitor and surveil the technology
Whereas historically server failures were IT problems, now
resilience and overall management of "failure domains" was
front and center a problem for the business, affecting
P&L. Eventually, even the regulators took notice,
giving us Reg SCI.
This shift was gradual, which afforded banks the luxury of
addressing the first-order problems (building these complex
systems) before creating and in turn addressing the
second-order problems of monitoring and stability.
This time around, it all needs to be done at once: the
difficulty of building a new swaps market structure overnight
compounds the need to monitor it vigilantly.
A fragmented market
The SEF market structure, like equity markets, is horizontal
and fragmented, where fungible swaps trade on multiple venues.
The race for SEF winners and losers is not complete, but
regardless of the outcome, the buy-side and sell-side will
connect to multiple SEFs.
This implies the need to watch multiple venues and multiple
price feeds. Ironically, in the absence of best execution
regulations, banks transacting on SEFs need increased scrutiny
of their flows.
Additionally, SEF execution methods include both RFQ and
order books; and dealers may also utilize Request for Stream
(RFS) mechanisms. Though the SEF will link the RFQ to the
order book, these separate mechanisms imply multiple flows that
the banks will want to watch.
It may be that, in time, something like Reg NMS is introduced
to mandate best execution, and that the SEF market might
consolidate, reducing the number of connections required.
Again though, the lack of an extended evolution means that
swaps traders need to adapt immediately to how things are
now, not how they might be in the future.
New entrants, new problems
If the immediacy of the new market structure and complexity
of its technology were not enough of an incentive to monitor
flows, there is the added dynamic that banks may find
themselves transacting on SEFs with some very sophisticated
technology players, who have embraced the new market structure
as playing to their strengths.
HFT and "Chicago style" electronic trading is not new to
other asset classes, but again, the issue is that elsewhere it
evolved over time, and banks built out their electronic trading
infrastructures concurrently with the growth of HFT.
The traditional bi-lateral swaps market was a closed,
invitation-only market, transacted primarily over the phone.
Now, the much-touted fair (read: open) access that the CFTC
demands of SEFs allows some sophisticated technology shops to
automate price making, previously the purview of dealers.
Those banks running a modern rates business need to
understand the quality and quantity of their prices, and the
speed of their contributions and responses.
This implies a very rapid change in technological
intermediation. The sell-side dealers are now potentially
competing with automated trading shops.
Now they have to ask: what are their infrastructure
latencies? Are they seeing prices rapidly enough? Responses?
And unlike stock trades, the basis point spreads in interest
rate swaps can translate to tens of thousands of dollars.
Where such metrics were once the province of IT
operations, now the trading desks themselves want this
Insight, not myopia
What does this insight include? Monitoring system
health (e.g. am I connected to the SEF?) should be a given for
any modern technology infrastructure. Monitoring latency
gives insight to the trading desk that the prices they are
seeing, as well as making, are rational.
Traders will want to know if they are falling behind
– either in SEF price feeds or, for example, in
responding to client RFQs. And finally, analytics of SEF
price and order data can give trading desks the confidence that
they are adequately navigating the new market structure.
For example, some SEF order books may become "toxic", as
liquidity at certain price points evaporates. This
insight is only available by monitoring these flows, and
applying appropriate analytics.
Rome wasn’t built in a day. Arguably, a market
structure isn’t as complicated as an empire, or
even a city; but there are bound to be problems when you create
a whole new market landscape at a stroke.
Swaps traders don’t have the luxury of figuring
it out as they go, while the market evolves around them
– as those in the equities (and other) worlds
That’s not to say that the new regulatory
requirements or the speed of their implementation are good or
bad; but the sheer complexity of the task makes it all the more
crucial that systems are properly monitored and stable from day
New swaps empires may have to be built in a day, but proper
technological oversight is needed to ensure they
won’t crumble just as fast.