The Street Wise Professor (SWP) takes another look at SEFs today, and explores the unintended consequences of SEF order handling rules.
He looks at the possibility that SEF execution mandates could over time result in a single dominant SEF execution venue.
Driven by the efficiencies of vertical integration of SEF execution with post trade clearing & settlement – much he argues will depend on whether SEFs will be mandated to route orders to other SEFs showing better prices (in similar way to equities under RegNMS).
Horizontal, independent clearers (or settlement providers) can survive in an OTC market, where there is no centralized execution venue. Vertical integration economizes on transactions costs and double-marginalization costs when there are back-to-back monopolies (and near monopolies). No execution venue, no back-to-back monopoly problem.
That’s where the SEF mandate comes in. By forcing exchange-like execution of swap transactions, there is a very real possibility that a dominant execution venue will emerge–and that the resulting frictions in the dealings between that venue and its clearer will lead to a merger between them (or some sort of long-term, exclusive contract.)
Bottom line, he agues is that
If SEFs are required to operate auction-like mechanisms, and are under no obligation to direct orders to markets displaying better prices, markets will tip to a single SEF. This will lead to integration. If regulators impose order handling obligations, multiple SEFs will survive, and integration is far less likely.