Streetwise Professor

September 10, 2014

SEFs: The Damn Dogs Won’t Eat It!

Filed under: Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 8:37 pm

There’s an old joke about a pet food manufacturer that mounts an all out marketing campaign for its new brand of dog food. It pulls out all the stops. Celebrity endorsements. Super Bowl Ad. You name it. But sales tank. The CEO calls the head of marketing onto the carpet and demands an explanation for the appalling sales. The marketing guy  answers: “It’s those damn dogs. They just won’t eat the stuff.”

That joke came to mind when reading about the CFTC’s frustration at the failure of SEFs to get traction. Most market  participants avoid using central limit order books (CLOBs), and prefer to trade by voice or Requests for Quotes (RFQs):

“The biggest surprise for me is the lack of interest from the buyside for [central limit order books or CLOB],” Michael O’Brien, director of global trading at Eaton Vance, said at the International Swaps and Derivatives Association conference in New York. “The best way to break up the dual market structure and boost transparency is through using a CLOB and I’m surprised at how slow progress has been.”

About two dozen Sefs have been established in the past year, but already some of these venues are struggling to register a presence. Instead, incumbent market players who have always dominated the swaps market are winning under the new regulatory regime, with the bulk of trading being done through Bloomberg, Tradeweb and interdealer brokers including IcapBGC and Tradition.

“It’s still very early,” Mr Massad told the FT. “The fact that we’re getting a decent volume of trading is encouraging but we are also looking at various issues to see how we can facilitate more trading and transparency.”

Regulators are less concerned about having a specific numbers of Sefs since the market is still sorting out which firms can serve their clients the best under the new regulatory system. What officials are watching closely is the continued use of RFQ systems rather than the transparent central order booking structure.

Not to say I told you so, but I told you so. I knew the dogs, and I knew they wouldn’t like the food.

This is why I labeled the SEF mandate as The Worst of Dodd Frank. It was a solution in search of a non-existent problem. It took a one-sized fits all approach, predicated on the view that centralized order driven markets are the best way to execute all transactions. It obsessed on pre-trade and post-trade price transparency, and totally overlooked the importance of counterparty transparency.

There is a diversity of trading mechanisms in virtually every financial market. Some types of trades and traders are economically executed in anonymous, centralized auction markets with pre- and post-trade price transparency. Other types of trades and traders-namely, big wholesale trades involving those trading to hedge or to rebalance portfolios, rather than to take advantage of information advantages-are most efficiently negotiated and executed face-to-face, with little (or delayed) post-trade price disclosure. This is why upstairs block markets always existed in stocks, and why dark pools exist now. It is one reason why OTC derivatives markets operated side-by-side with futures markets offering similar products.

As I noted at the time, sophisticated buy siders in derivatives markets had the opportunity to trade in futures markets but chose to trade OTC. Moreover, the buy side was very resistant to the SEF mandate despite the fact that they were the supposed beneficiaries of a more transparent (in some dimensions!) and more competitive (allegedly) trading mechanism. The Frankendodd crowd argued that SEFs would break a cabal of dealers that exploited their customers and profited from the opacity of the market.

But the customers weren’t buying it. So you had to believe that either they knew what they were talking about, or were the victims of Stockholm Syndrome leaping to the defense of the dealers that held them captive.

My mantra was a diversity of mechanisms for a diversity of trades and traders.  Frankendodd attempts to create a monoculture and impose a standardized market structure for all participants. It says to the buy side: here’s your dinner, and you’ll like it, dammit! It’s good for you!

But the buy side knows what it likes, and is pushing away the bowl.

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  1. So the five stages of grief are usually said to be

    1 Denial
    2 Anger
    3 Bargaining
    4 Depression
    5 Acceptance

    What’s the betting the pols remain permanently stuck between 1 and 2….

    Comment by Green as Grass — September 11, 2014 @ 2:06 am

  2. Tell you what, if I would become a markets professional, with all the courses and certifications and all that jazz would be exactly for this SEF thing. I am a retail trader and I hate it passionately; I hate this two-tiered financial world, where all the goodies are beyond the barb wire fence that separates retail from professional, when it comes to bespoke derivatives and risk management. I don’t understand why the professional buy side would give away price transparency. It’s not logical. I see the sell side very pissed off about Dodd-Frank. Now it looks like a multiple monopoly, where each sell side quotes whatever it wants, and however it wants, to the buy side. Dodd-Frank SEFs are making the pricing better: from monopoly to cartel. It’s not too much, but it’s certainly an improvement. And they don’t like it. They probably blame the buy side, constantly lobbying against the Dodd-Frank to have the law if not repelled, at least modified, because it’s against their interests. Why would someone trade derivatives in a RFQ system? RFQ can be used properly when using static hedging. However, trading is inherently dynamic, and dynamic hedging can’t work with RFQ. Because you’re blind. You can’t know how fair would be the price when you EXIT the strategy. RFS however, is more dangerous for the sell side. Because the client learns the pricing patterns and can assess easily the quality of pricing, and with that the decision – to trade or not to trade with a given sell side partner. When I got out of my retail trading, my binary options broker had an RFS system. All exotics were quoted bid/ask, continuously all the way to expiry. No RFQ tricks. I knew the game was over because I was looking at the prices. From 20 trades a day to 2 trades a week. I had to close my trading down. But how would it have been, should that system been a SEF ? Of course, in a cartel they can collectively improve their pricing against me, but there is still some competition. I wouldn’t expect to see all providers quoting the same price. And it’s certainly a way more regulated environment than I could ever expect in retail, where regulators are partnering with brokers to prey on clients…

    Comment by Bogdan — September 11, 2014 @ 6:16 am

  3. In a nutshell, what we are saying here is that the Regulatory structure and the “depth” of thought behind it most closely resembles Michelle )’s school lunch menu.

    Comment by Sotos — September 12, 2014 @ 7:39 am

  4. Hey warmongering Russophobe! Did ya see that PorkoChoco has delayed the EU association agreement? Probably for the same reason that Yanukovich turned it down, namely that its a total screwjob on Ukraine…

    Good thing he’s sent all the Maidannuts off to get killed in Novorossia, or the delusional Banderastanis would now be rising against him!

    Comment by wanderer3762 — September 13, 2014 @ 6:47 am

  5. […] this raises the dog food question: If the dog food is as great as the ads say, why don’t the dogs eat it? if SEFs are so much more liquid, why don’t traders flock to […]

    Pingback by Streetwise Professor » Swaps Execution: The Dogs Still Don’t Eat the Dog Food When They Have the Choice — January 26, 2016 @ 9:03 pm

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