Too much power: Sefs warn on 'available to trade' rules

Final execution rules in the US have given swap execution facilities the power to determine what products they will be allowed to trade. The entire industry appears to agree this is a terrible idea – including the trading venues themselves. Peter Madigan reports

It is rare to hear regulated entities complain that a new rule gives them too much freedom, but since final rules for swap execution facilities (Sefs) were agreed on May 16, some of these venues – including Tradeweb – have been warning about the amount of latitude they have to decide which products fall into their market.

The Dodd-Frank Act states that an over-the-counter swap must be executed on a Sef or an exchange when it has been made available to trade (MAT) by one of the new platforms – making it illegal to execute bilaterally from that point on. Each platform will be allowed to list products as it sees fit, submitting them to the Commodity Futures Trading Commission (CFTC) for review – but under the fast-track version of this procedure, the platform itself would be responsible for assessing the suitability of a product for Sef trading, subject to a 10-day review period by the regulator. If no objections are raised by the CFTC, the product would be certified at the end of this period. Thirty days later, it would become a legal requirement for market participants to execute the product on a Sef. That has triggered sharp criticism from buy-side firms and dealers – and some Sefs share their fears.

“On the MAT concept we would have preferred something to be fixed for a year, with a chance to review what is happening in the market before deciding the next steps. We would have preferred something that is driven by the regulator, and there is plenty of concern out there that anyone who files as a Sef has the ability to set standards for the whole market. The concept of new products being made available to trade on a regular basis will create challenges for everybody to try to keep up with,” says Lee Olesky, chief executive of Tradeweb in New York.

The head of trading at another large US venue warns that if one Sef tries to list a product, others will be forced to follow. “The MAT rule invites a race to the bottom by allowing Sefs to use one of six determinants to come up with a belief that a given product should trade on a Sef. We are going to work with our liquidity providers to make a determination around which products we think have enough liquidity for MAT status – we will not decide that independently. But when other Sefs list products, that forces our hand to trade those products through our Sef also,” he says.

Effectively, the fear among market participants is that an aggressive platform will list products that others have shunned, potentially creating a monopoly for itself, and dragging swaps that ought to be executed bilaterally into a world of 15-second transaction delays, minimum quote requests and central limit order books – measures designed to promote competition and transparency, but which will drive up costs and hurt liquidity, according to some (see box, The Sef rules’ sleight of hand).

There is plenty of concern out there that anyone who files as a Sef has the ability to set standards for the whole market

There are some safeguards. The first is a requirement that a platform or an exchange – known as a designated contract market (DCM) in regulatory jargon – considers six criteria when self-certifying a product as available for trade: whether there are ready and willing buyers and sellers; the frequency or size of transactions; the trading volume; the number and types of market participants; the bid-offer spread; and the usual number of resting bids and offers.

No detail is given on how – or whether – a Sef should show it has taken these factors into account, and critics argue the factors themselves are too subjective. These critics include CFTC commissioner Scott O’Malia, who observed when dissenting from the final rule that it “allows a Sef or a DCM to make a MAT determination based solely on factors it deems relevant, while ignoring other considerations that may be of vital importance. The lack of specific, objective criteria for determining trading liquidity makes it unfeasible for the commission to have any meaningful regulatory oversight over the MAT determination process.”

There is also little detail on how the CFTC will review a Sef’s submission to make a product available for trading. “The commission has 10 business days to review the rule before it is deemed certified and can be made effective,” the text states – implying that, as long as the CFTC does not object, market participants will be required by law to stop trading a product bilaterally, a cutoff that arrives 30 days after the product becomes available. If the CFTC has an objection to a self-certified product, it can stay the certification for 90 days and launch a 30-day public comment period.

Block trades could still be executed away from a Sef or exchange, but the block size threshold – 67% of the range of notional sizes for any given product – was also finalised during the May 16 meeting. That exemption would currently apply to around 6% of transactions in the interest rate swap and credit default swap markets, meaning the remaining 94% would be subject to the Sef-execution requirement following an MAT determination (Risk April 2012, pages 26–29).  

The alternative to self-certification is for Sefs and exchanges to submit a request to the CFTC – subjecting products to a more thorough 45-day review from the commission, with a further 45 days available if necessary. The expectation among dealers is that the quicker, self-certification route will be more popular – and that products will begin disappearing from the bilateral market soon after Sefs are themselves given the green light to start operating. October 2 is the earliest date on which the first platforms could be up and running – 120 days after the rules were published in the Federal Register – and swaps could become subject to mandatory Sef execution from November 15, (see box, From soup to nuts in 35 months).

“The MAT rule is as bad as it can be. It’s a free-for-all, a race to the bottom in which the fox is left to guard the hen house. Under this rule there are no brakes on how fast every product becomes mandatorily Sef traded and that is not good for liquidity. This is a very poor outcome,” says one New York-based dealer.

A swaps trader at another bank sees it the same way. “If a Sef start-up identifies a forward-dated swap that no other Sef is trading and it decides to list the product on its platform, unless the CFTC baulks, the product becomes subject to mandatory Sef trading 30 days later – and unless other Sefs figure out a way to list it on their platform, the original venue has a monopoly. As a dealer, I may have no connectivity to that venue, but now I am not legally able to offer that contract to my clients in the US unless I trade it on a Sef. There is no incentive for Sefs to not list absolutely every product that they can – it’s crazy,” says an interest rate swaps trader in New York.

In the final rule, the CFTC says it received several comment letters warning that Sefs “may have a financial incentive-based conflict of interest to maximise the number of swaps subject to mandatory trade execution” in order to gain a first-mover advantage.

As a result, the commission enacted the rule with one additional safety valve: “The commission has determined that at this time, it will only review available-to-trade submissions for swaps that it has first determined to be subject to the clearing requirement,” the rule reads (Risk March 2012, pages 26–28).

The rule does not say, however, what “at this time” means, and whether the prerequisite that an MAT determination can only be made on clearing-mandated swaps is permanent. But even within the universe of cleared trades, critics argue many products would be unsuitable for execution in the more transparent, faster-paced environment of a Sef or exchange.

Dealers use the broad category of short-dated swaps to illustrate the point. Short duration swaps such as forward rate agreements, overnight indexed swaps or basis swaps are already subject to the CFTC clearing mandate, but they remain largely customised in nature. Few dealers make markets electronically in these products today, but they worry a start-up Sef could look to corner the market by making the contracts available to trade.

These complaints will prove academic if the self-certification and review process prevents illiquid or otherwise unsuitable products from being given an MAT determination, but derivatives lawyers are not confident – and point to the final rule’s cost-benefit analysis as evidence. For each self-certification, the CFTC estimates a Sef or exchange will require two staff – an economist and a compliance officer – to analyse the six factors involved, with each expected to spend eight hours on the task. This leads the agency to claim it would cost a trading venue a maximum of $938.40 to certify a product as available for trading.  

“The CFTC’s approach to MAT is altogether too casual. The commission estimated it would take a day for a compliance person and an economist to do the MAT analysis so, in the opinion of the CFTC, the total cost of determining whether a swap should be executed on a Sef is $900. The consequences of this approach are serious, affecting whether potentially trillions of dollars’ worth of trades move onto Sefs. Allowing that to rest on a superficial $900 analysis done by a compliance person is worrisome from a policy point of view. There is much in Dodd-Frank to be concerned with, but this is pretty high up on the list,” says Steven Lofchie, a partner in the derivatives practice at law firm Cadwalader Wickersham & Taft in New York.

There will still be a CFTC review, of course, but commissioner O’Malia’s dissenting statement warned against putting too much faith in this process. “The rule provides illusory comfort that the commission will have a legal authority to review and, if necessary, challenge a mandatory trading determination made by a Sef or DCM. In fact, the only authority the commission has is to rubber stamp a Sef or DCM’s initial determination,” wrote O’Malia. He argued that the CFTC can only reject a self-certified product if it contravenes the agency’s rules – and because those rules simply require a platform to consider a series of factors, it will be difficult to show that a breach has occurred.

So, what happens if a product proves unsuitable for Sef trading – perhaps because liquidity in the contract shrinks? Lawyers wanted to see some kind of procedure for MAT status to be removed from a product, handing it back to the OTC market. Nothing of that sort exists. Instead, the rule says a swap will remain subject to the new execution rules as long as it is listed by at least one Sef or DCM.

“There is no clear process for making a swap no longer available to trade and that is a problem. If at some point the liquidity in a given product decreases to the point where it is not appropriate to call for it to be mandatorily executed on a Sef, there is no clear process to take that product down unless all Sefs and DCMs delist and there may not be an incentive for Sefs and DCMs to do that. This is just another one of the many elements in the rule that is troubling,” says Daniel Budofsky, a partner in the derivatives and structured products group at law firm Davis Polk & Wardwell in New York.

 

BOX: The Sef rules’ sleight of hand
Anyone speed-reading the 130 pages of the final rule on swap execution facilities (Sefs) may come away with the impression that the Commodity Futures Trading Commission (CFTC) had significantly watered down its original January 2011 proposals, and much of the coverage that followed the May 16 meeting took that line (Risk April 2011, pages 60–62).

The requirement that a request for quote (RFQ) be sent to a minimum of five dealers was cut to a minimum of three – and just two for the first year of the trading mandate. Transactions can still be concluded over the phone, despite fears the CFTC would insist on electronic-only Sefs. And the unpopular 15-second crossing delay – designed to allow other dealers to better the price offered by a rival – has also been softened.

It all seems like encouraging news for market participants that feared the proposed rules would smother the over-the-counter market. But a closer reading reveals some caveats. In many cases, while amending the original text, the CFTC has given itself the flexibility to toughen the regime up in future – a hint at how bruising the debate over the rules was, dividing the CFTC’s five commissioners, and at the compromises struck to get the new regime passed.

“I wasn’t surprised with some of the concessions in the final Sef rule given how long it took to finalise. You still have front-running and increased cost concerns on the RFQ – even though it is only going out to three counterparties rather than five; you still have the 15-second crossing delay that – even if shortened by a Sef – will heighten dealer uncertainty and lead to higher pricing. In many cases, I don’t think the final rule solves many of the concerns that were raised by the initial proposals,” says Michael O’Brien, a partner specialising in derivatives at law firm Winston & Strawn in Chicago.

The 15-second crossing delay
The CFTC’s 15-second delay for prearranged trades or the matching of two client orders on a Sef’s order book – designed to give other dealers “the opportunity to join or participate in the trade” – survives largely intact, with one substantial change.

“The commission believes that the 15-second time delay requirement should serve as a default time delay. The commission is revising the rule to allow Sefs to adjust the time period of the delay, based upon liquidity or other product-specific considerations,” the text states. Any request to apply a different time period must be submitted to the CFTC for review, and the commission has the ability to reject an application if it wants. 

Dealers have always been sceptical that the rule would deliver the promised benefit of better prices for customers – instead arguing that, if a market-maker has to worry about a competitor poaching a trade, it will quote a higher price and apply wider spreads. And if clients can obtain a tighter price through the RFQ process than in the order book, they will probably go for the former, rendering the 15-second rule superfluous. Or so the argument goes.  

“Most of the buy side has written off the 15-second rule as something they will not utilise. The market-maker has provided a price 15 seconds ago and taken on the risk that the trade might get done. The dealer cannot hedge that risk because the trade is not over yet and another dealer could swoop in and take the trade. It’s a very awkward position and, as such, the price offered to the client would have to include some compensation for the one-way risk the dealer is taking on,” says one head of electronic market-making at a major dealer.

Another New York-based dealer agrees: “As a dealer, am I going to worsen my price if I have to hold it for 15 seconds, and how much am I going to worsen it by? I don’t think anybody is going to use the 15-second rule. I think it is just a redundant feature. Why wouldn’t a customer simply come on to the system and RFQ me right away? Why would they agree a price with me and then wait 15 seconds?”

RFQ5 to RFQ3
Perhaps the clearest concession made by the CFTC is the decision to allow users of an RFQ system to approach only three dealers, rather than five – and just two until October 2, 2014. The change seems material but the rule’s critics are not satisfied.

“We remain concerned with the final rule on RFQs, even after the move from RFQ5 to RFQ3, or even RFQ2 during the phase-in period. The only thing that would have really satisfied us is no minimum quote requirement at all. You will still end up with information leaking into the market when you require a request for a quote to be submitted to more than one provider and other market participants can trade around that information to the disadvantage of the counterparty that put the bid out there in the first instance,” says Matt Nevins, associate general counsel at the Securities Industry and Financial Markets Association in New York.

The fear is the same as that in an RFQ5 world – once dealers know about the trade, pricing will be adjusted in anticipation of the need to hedge. A minimum of three participants mitigates the risk somewhat, but does not remove it.

“I’m not convinced dealers will put up their true, bottom-line best price because they have to take into account the risk that they will be front-run on the hedge. That additional risk will obviously not result in optimal pricing for the requesting party,” says O’Brien of Winston & Strawn.

Voice-executed trades
To the relief of interdealer brokers that have developed hybrid platforms offering electronic and voice execution, the final rules clarified that proposed language allowing swaps to be traded by “any means of interstate commerce” includes the telephone.

Questions remain, however. The rule requires accurate time-stamping of data relating to each transaction as well as an audit trail and other reporting requirements. For a voice-based Sef, the rule clarifies that the audit trail should include recordings of all communications that relate to swap transactions both outside the Sef and within, and it must be possible to trace the entire history of the trade through these recordings, which also have to be fully searchable.

Satisfying these reporting and audit requirements will be costly and cumbersome, experts warn. One interest rate trader suggests the reporting burdens have been made deliberately intensive, in order to dissuade the take-up of non-electronic execution methods.

“[CFTC chairman] Gary Gensler has been openly opposed to permitting voice trading, but the interstate commerce clause made it impossible to prohibit voice altogether. Instead, he has tried to make it as difficult as possible for the voice-broking guys to come up with a mechanism to document how they have got two prices together on an RFQ,” says the trader.

Sef aggregation
The rules prevent existing single-dealer platforms from acting as Sefs – they run into ownership restrictions as well as a requirement for a Sef to provide many-to-many trading – but many big dealers are hoping to make their investments pay off by aggregating prices shown by the new platforms, providing clients with access to the best price available at any one time and, potentially, more liquidity. The question has been whether an aggregator should itself have to register as a Sef, and the final rules say it should not – but only because the service is simply routing client trades to one of the underlying venues.

That removes the potential compliance burden, but creates other obstacles. If the transaction is still executed on a Sef, it seems to require the client to have signed up with that platform – obviating the need for an aggregator.  

Some buy-side firms still like the idea of the service, though – if only to keep tabs on prices, products and liquidity at Sefs to which they are not connected.

“One concern is that a Sef that is not that well known figures out a way to make a product available to trade and takes it out of the bilateral world,” said Supurna VedBrat, co-head of electronic trading and market structure at BlackRock, speaking at Risk’s OTC Derivatives Clearing Summit on June 5. “We want to be able to have the ability to aggregate the Sefs that we won’t be connecting to and see those through an aggregator. We like the concept and the ability of the market to use an aggregator, but when we speak with the individual Sefs they say they don’t want to be aggregated, so we will have to wait and see how that scenario plays out.”

Attitudes to aggregation vary from one trading venue to another. Tradeweb, for example, argues it already acts as an aggregator by bringing together quotes from the leading dealers.

“Our view is that we like to be right in front of our customers and we expect to continue that model where we are embedded in the desktop, and they will be able to get all the liquidity they need through us aggregating prices from liquidity providers. I don’t expect that many Sefs to be competing in the same instruments – I just don’t see the value proposition,” says Lee Olesky, chief executive of Tradeweb in New York.

 

TIMELINE: From soup to nuts in 35 months

• January 7, 2011: Commodity Futures Trading Commission (CFTC) Proposed rule: Core Principles and Other Requirements for Swap Execution Facilities.
• December 14, 2011: CFTC Proposed rule: Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade under Section 2(h)(8) of the Commodity Exchange Act.
• February 23, 2012: CFTC Proposed rule: Procedures to Establish Appropriate Minimum Block Sizes for Large Notional Off-Facility Swaps and Block Trades.
• May 16, 2013: CFTC meeting to vote on all three proposals. Sef core principles passes on a 4-1 vote, the made available to trade rule passes on a 3-2 vote, while the block trade rules also pass on a 3-2 vote.
• May 31, 2013: Block trade rules enter the Federal Register.
• June 4, 2013: The Sef and made available to trade rules enter the Federal Register.
• July 31, 2013: Block trade rules become effective.
• August 5, 2013: The Sef and made available to trade rules become
  effective.
• October 2, 2013: The earliest date at which a Sef will be able to start operating – 120 days after the rules were published in the Federal Register. Sefs can then submit MAT self-certifications to the CFTC.
• October 16, 2013: The earliest date that a swap could be certified MAT – 10 business days after the self-certification is submitted to the CFTC. The swap would now be available to execute on at least one Sef.
• November 15, 2013: The earliest date that a swap would be subject to mandatory execution on Sefs – 30 days after the CFTC certified that product to be available on a single Sef.