FX swaps: Market players grapple with fragmentation risk
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FX swaps: Market players grapple with fragmentation risk

Market participants are relatively relaxed about the impact of last year’s change to the US trading model, relative to the dire warnings from the global trade association for OTC derivatives, but global market fragmentation remains a risk.

In the 12 months since it was introduced in the US, swap execution facility (SEF) trading has contributed to the fragmentation of derivatives markets along geographic lines, according to the International Swaps and Derivatives Association (ISDA).

The ISDA says non-US firms - not yet required by their domestic regulations to trade on electronic platforms or clear their derivatives transactions - are avoiding trading mandated products with US firms where possible, as doing so would mean they would need to trade on SEFs and clear through central counterparties before their own country’s regulations require them to do so.

When asked whether the diversion of trade flows to markets outside the US was a worrying development, an ISDA spokesperson observed that over-the-counter (OTC) FX products (options and non-deliverable forward contracts) are not yet subject to mandatory SEF trading in the US, which means US persons are not obliged to trade these instruments on the venues.

“As a general point, though, many non-US participants are opting to trade mandated products with other non-US participants to avoid the challenge of being compliant with Dodd-Frank requirements,” he adds.

Dodd-Frank has created a situation where
other jurisdictions are more attractive to trade
these types of derivatives in than the US

Zohar Hod

However, SuperDerivatives global head of support Zohar Hod suggests the US trading model is improving, adding: “There remains a great deal to be done in terms of liquidity and addressing the absence of a homogenous regulatory environment globally. However, I feel that SEFs will eventually prove to be a success, albeit with fewer venues than we have now.”

He accepts that market fragmentation creates buy-side issues around the amount of technology that needs to be put in place to reach liquidity providers. 

“The ability to do some of this trading on exchanges as well as SEFs creates issues for certain global players who might prefer one territory over another, but variety is not necessarily a bad thing," says Hod. "Problems arise when there is too much variety as this makes it harder for the end-user to find a good price.”

Worrying development

Hod describes trade flows to markets outside the US as a worrying development for investment managers who don’t have the option of setting up a facility in Singapore or London and therefore face either higher prices or having to provide more collateral to do trades.

“Dodd-Frank has created a situation where other jurisdictions are more attractive to trade these types of derivatives in than the US," he says. "Because of EMIR we have a situation in Europe where infrastructure has been improved because it is perceived as a better place to trade FX.”

Chris Ferreri, head of ecommerce Americas at Icap, suggests that OTC market fragmentation has been caused by the overall regulatory framework rather than just the introduction of the swap execution facility.

“We have said from the earliest stages of the Dodd-Frank process that the interdealer brokers were the central marketplaces for derivatives," he says. "We competed with each other, we didn’t take a position on the market and we saw ourselves as the model for the SEF. 

"Almost five years later and, after the introduction of SEFs, the data is showing us that the incumbents are doing most of the business.”

He says if there were higher volatility in the market there would likely be more trading activity and that derivatives trading volumes have suffered as a result of the current low-volatility environment.

Data on trading activity in OTC products indicates that while there is US-based liquidity, firms have been diverting trade flows to markets outside the US to circumvent the venues. 

However, Ferreri does not accept that this loss of liquidity is necessarily a worrying development, adding: “This scenario has been characterized as avoidance of SEF trading, but I would describe it as trading on the platforms where liquidity exists.”

This view is shared by Scott Fitzpatrick, executive director of strategy and business development at Tradition. 

“It is not necessarily a loss of liquidity; it simply means that the liquidity moves offshore”, he says. 

Nevertheless, he also accepts that for firms operating from a single location - for example, supporting activity in the US alone - this would be a concerning development.

On the question of whether cross-border collaboration will increase once European trade reporting and post-trade processing rules are finalized, Ferreri says it is significant that Timothy Massad’s first act on taking over as chairman of the Commodity Futures Trading Commission was to fly to Europe.

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