Added costs of OTC derivatives debated

The debate about SEFs, exchanges and the OTC derivatives market is not going away.

Until we get an actual date as to when the new rules will actually kick in, the effects of the Dodd-Frank-inspired reform of the market will remain a question mark. You can argue every which way. The idea of bringing phone-based OTC trading onto formal exchanges and so-called swap execution facilities sounds like a great idea for the reform-minded, hence their passage as part of Dodd-Frank. Many think this transparency will come with tremendous costs. More firms will be forced to avail themselves of liquidity aggregation tools and smart routers to best deal with the multiple new liquidity centers, all of which will have heightened audit and compliance-oriented tools in place.

Many have predicted the result to be more fragmented markets for derivatives and higher costs marbled in throughout the system. But Advanced Trading weighs in, noting the other side of the debate, which is that the need for liquidity aggregation tools and smart order routers has been overstated. Indeed, perhaps the whole fragmentation idea has been overplayed.

On expert predicts that, "You will likely have two central counterparties (CCPs) per asset class clearing all standard trades. Sell side revenue will come from clearing, flow market making on SEFs or off SEF block trades, and bi-lateral trades for non-standard structures."

There will be heightened costs initially, however. One development that looms significant: Enhanced competition at the SEF level by buy-side firms and custodial companies. State Street, for example, recently announced that it intended to join the SEF sweepstakes.

One executive told the Financial Times that, "It became very clear to us that this offered us an opportunity to trade in the [OTC] derivatives market, and to do so in direct competition with the sellside, and we're very excited about that."

State Street intends to compete by offering end-to-end services that link execution to custodial services, clearing and settling.  It says its new SEF will provide "the first step in a global end-to-end solution that reduces operational risk through the automation of the many stages of derivatives processing, including execution, clearing, collateral management, cash and securities flows between the middle and back offices, transaction cost and risk reporting, valuations, and the reconciliation of positions." -Jim