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SEF Trading Has Accelerated Market Fragmentation – ISDA

Over-the-counter derivative markets have fragmented along geographical lines since the start of the swap execution facility regime in the US in October 2013, according to research from the International Swaps and Derivatives Association (ISDA).

That trend has been especially notable for euro interest rate swaps, with European dealers opting to trade with other European parties instead of their US counterparts, the association finds.

According to the research, which is based on monthly regional clearing data from LCH.Clearnet between January 2013 and May 2014, the average volume of euro IRS transacted between European dealers as a percentage of total euro IRS volume was 75% between January and September 2013.

“Trading between US persons and non-US persons has declined,” ISDA says. “Most notably, fragmentation is disrupting the market for euro interest rate swaps as liquidity pools have become more exclusive among European dealers.”

In the period following the implementation of the SEF rule – October 2013 through January 2014 – this average rose to 90%.

From February 2014, when derivatives products were mandated for SEF trading in the US – a process called made-available-to-trade – to May 2014, it had risen to 93%.

The percentage of euro IRS volumes transacted between European and US dealers declined significantly in the same period, from 25% between January and September 2013 to 9% in January 2014 and 6% by May.

Similar themes can be identified in an analysis of US dollar IRS with European dealers primarily trading US dollar IRS with other European dealers, albeit to a lesser degree.

From January 2013 to September 2013, an average of 52% of cleared US dollar IRS was traded exclusively in Europe. Transactions occurring between European dealers and US dealers accounted for an average of 43% of activity during this time.

Following the October 2013 SEF rule implementation date ISDA found clear shifts in trading behaviour.

During the months of October, November and December, there was an increase in average European-to-European interdealer activity from 52% to 58%, coupled with a decrease in average European-to-US interdealer activity from 43% to 38%.

However since January 2014, relationship trends appear to have normalised to the period preceding the SEF rule.

“This may be because the market for US IRS is US-centric, whereas the market for euro IRS has a more global character and is thus more prone to fragmentation,” ISDA says.

ISDA also used data from the DTCC’s Global Trade Repository to examine euro and US dollar SEF volumes.

Given the SEF rules apply to any eligible trade involving a US person, it is perhaps not surprising that 70% of IRS volume transacted on SEFs, on average, was denominated in US dollars once the October 2013 rule was implemented.

The percentage of euro trading on SEF decreased once the first MAT determinations came into force in February 2014.

Between October 2013 and January 2014, the average percentage of euro trades was 13%. This average decreased to 9% between February 2014 and May 2014.

“The 2 October effective date for SEF compliance has clearly had an impact on trading relationships in the OTC derivatives markets,” ISDA concludes.

“Our updated empirical analysis supports recent December 2013 ISDA survey findings indicating that liquidity has further fragmented following the first MAT determinations coming into force on 15 February 2014.”

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