Mechanism Selection and Trade Formation on Swap Execution Facilities: Evidence from Index CDS
47 Pages Posted: 4 Oct 2017 Last revised: 3 Nov 2017
Date Written: September 29, 2017
The Dodd-Frank Act mandates that certain standard OTC derivatives be traded on swap execution facilities (SEF). This paper provides a granular analysis of SEF trading mechanisms, using message-level data for May 2016 from the two largest customer-to-dealer SEFs in index CDS markets. Both SEFs offer various execution mechanisms that differ in how widely customers' trading interests are exposed to dealers. A theoretical model shows that although exposing the order to more dealers increases competition, it also causes a more severe winner's curse. Consistent with this trade-off, the data show that customers contact fewer dealers if the trade size is larger or nonstandard. Dealers are more likely to respond to customers' inquiries if fewer dealers are involved in competition, if the notional size is larger, or if more dealers are making markets. Finally, dealers' quoted spreads and customers' transaction costs increase in notional quantity and the number of dealers involved. In addition to results related to the winner's curse, past trading relationships also affect customers' requests and dealers' responses. Our results contribute to the understanding of swaps markets by providing insights into the trade-offs faced by investors and dealers.
Keywords: Swap Execution Facility, Dodd-Frank Act, OTC Derivatives, Competition, Winner's Curse
JEL Classification: G01, G12, G14, G18
Suggested Citation: Suggested Citation