In a paper published today, the International Swaps and Derivatives Association, Inc. (ISDA) outlined its views on the role, impact and optimal structure for Swap Execution Facilities (SEFs*) in the global over-the-counter (OTC) derivatives markets.
Core SEF Principles
ISDA believes that SEFs can play a positive role in the over-the-counter derivatives market by strengthening its infrastructure, helping prevent insider trading and other market abuse, and increasing transparency and access for smaller participants. To achieve this potential and become an effective marketplace, SEFs need to offer derivative users broad choice in trade execution at very low cost. SEFs should be structured to, among other things:
* Provide maximum choice in trade execution to market participants;
* Provide pre- and post-trade transparency while maintaining liquidity;
* Have reasonable, tailored and product specific block trade exemptions that reflect the risk of a transaction instead of a "one size fits all" approach;
* Grant access to a broad range of qualified market participants. Access rules should be objective and applied impartially;
* Be flexible enough to allow business models to evolve over time;
* Products required to be traded in SEFs should be limited to liquid, mature products;
* Rules should not be simply imported from other, fundamentally different markets but should take into account the liquidity, average trade size and average trade frequency of the derivative products and the relative sophistication of the market participants.
It is also essential that individual SEFs are not discriminated against by central clearing organizations in terms of access and pricing.
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*SEFs are a type of trading system, as defined in the US by the Dodd-Frank Act (DFA). The law requires derivatives subject to mandatory clearing to trade on them provided that such derivatives are made available for trading by the SEF.
Financial Market Structures and Trading
In the paper, ISDA also noted the substantial differences between various segments of the financial markets and how trading has evolved in them. The exchange-traded futures market is characterized by a broad range of trading customersrading rading customers (including retail customers) meeting margin requirements to transact a small number of highly standardized contracts in relatively small amounts. As a result, liquidity in exchange-traded markets is relatively continuous in character.
By contrast, the number of potential buyers and sellers in the OTC derivatives markets is relatively small. Active participants are sophisticated institutions who extract very competitive pricing from multiple dealers. Trading is comprised of a wide array of less-standardized products. Trades are typically much larger in size and much less frequent. Liquidity levels are highly variable and depend, to a very large extent, on a dealer making prices for clients.
Different structures have also emerged for other market segments. This includes trading in US treasuries, arguably one of the most liquid financial instruments in existence. A large portion of trading in the so-called "on-the-run" treasuries, those most recently issued and most liquid, is conducted on electronic trading platforms. A substantial portion of trading in older, "off-the-run" treasuries is still done through wholesale brokers and directly between dealers. There is no requirement that any trades be made entirely on electronic platforms.
Review of Current Regulatory Proposals
ISDA believes that regulatory proposals mandating the use of SEFs for derivatives trading should be based on the core principles outlined in the paper and the structure of the OTC derivatives markets. In its paper, the Association suggests several areas for improvement:
Determining whether a derivatives product is available for trading by a SEF: The CFTC proposes to delegate this responsibility to the SEF and further proposes that if one SEF has made such a determination, all SEFs would be required to treat the swap as made available for trading.
The proposed rule does not, however, set out any specific criteria to determine whether a derivative product has the liquidity to trade. The CFTC should state that a contract subject to mandatory clearing does not automatically make it available for trading and that the contract must also meet minimum liquidity and standardization characteristics.
The proposed rule also creates a misalignment of interest in that SEFs will have every incentive to declare a product available for trading in order to capture market share. Furthermore, if a product trades very infrequently and every trade executed is known to the entire market as a result of SEF execution, participants will be very cautious in taking on positions. The result will be less liquidity and worse pricing for users. To eliminate this conflict of interest and its negative implications, the CFTC should make the "available to trade" determination - subject to public notice and comment.
Requiring that SEFS either be Order Books or request for quote (RFQ) facilities. ISDA's paper argues that this requirement is an unnecessarily narrow reading of the DFA. It is difficult to see the advantage of requiring only two types of facilities to qualify as SEFs when other types of facilities might easily accomplish the goals of DFA.
The CFTC further states that a participant utilizing a RFQ must send the request to at least five participants. This appears to be another example where the CFTC is being more precise and restrictive than it needs to be. The DFA states that participants must only have the ability to accept multiple bids or offers - not that they are required to ask for them.
Requiring bids or offers from five dealers may make dealers hesitant to price the transaction aggressively as at least four other market participants will know of their winning position. There may be other swaps that represent hedges for confidential transactions and should not be presented to five dealers. The five dealer requirement limits how participants operate in markets when it does not serve clear purposes. The requirement is bound to reduce liquidity.