The over-the-counter credit default swap market took its first steps onto exchanges this week, as current CDS contracts referencing investment-grade and high-yield corporates were mandated to trade on swap execution facilities.
The first wave of affected contracts represent around 10 per cent of the total US$24 trillion gross notional outstanding in CDS across the two relevant series, according to DTCC data. Clients will still be able to contact dealers for quotes on specific five-year contracts, but firms will have to reach out to at least two sellside entities and the prices will have to be entered into the electronic SEF platform prior to execution. Despite concerns about readiness, the market is prepared for the shift, which comes a week after interest rate swap benchmark contracts came under SEF jurisdiction. "Volumes came off a bit but overall liquidity was preserved and there was minimal disruption", said Laurent Samama, head of US credit trading at BNP Paribas. As the market gets comfortable with the new structure, trading relationships will change - and platforms will jockey for revenues.
Electronic execution opens the door to a broker-style model in which banks connect to platforms and execute for clients on an agency basis, allowing the client to step back from the reporting requirements associated with SEF connection. Some believe the IB-style model is the future of swaps trading, as it eases burdens for clients associated with direct SEF connection. To work efficiently, introducing brokers would need to access a range of registered platforms. But some SEFs appear to be pushing back against the move to protect the status quo.
Meanwhile many banks are sceptical, because a dramatic shift away from the traditional principal-based execution model for swaps trading will hurt the revenues of major dealers. Investors are watching to see if planned listings of CDS futures will provide a better way to hedge credit exposures. Others are also looking to capitalise. Start-up SEF trueEX hopes to launch a credit future in the second quarter, while GFI is in discussions on a possible hybrid product. Some predicted swap futures volumes could spike on the back of the commencement of mandatory swap trading on SEFs. However, if the experience of the rates market's shift into the electronic world a week previously is any indicator, operational SEF issues may not be the fire-starter once imagined.
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