Derivatives Reform Is a Thorny Rose

By Will Rhode, TABB Group

Originally published on TABB Forum 

For those who feared that the derivatives industry had had its fill of regulatory debate, there is still plenty of fodder for discussion as the process of Dodd-Frank implementation rolls on. 

For those who feared (or perhaps hoped) that the derivatives industry had had its fill of regulatory debate, participants at this year’s SEFCON IV conference in New York demonstrated that there is still plenty of fodder for discussion as the process of Dodd-Frank implementation rolls on.

Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler kicked off proceedings by attacking so-called “enablement mechanisms” on dealer-to-customer (D2C) Swap Execution Facilities (SEFs). This is a legacy system that gives dealers the opportunity to screen clients before allowing them access to their bids and offers on an electronic swaps trading platform. Now the CFTC says such enablement mechanisms are not consistent with the impartial access rule governing SEFs. In a Bloomberg news report, some of the SEFs reported that they will change their procedures in response to the CFTC guidance.

Chairman Gensler also attacked SEFs that require participants to be a swap dealer or a clearing member. “SEF registration was not meant to be just business as usual,” he said. “Bringing access to the entire marketplace means platforms will no longer be just dealer-to-dealer, or dealer-to-customer.”

This is music to the ears of the interdealer-brokers (IDBs) that organize SEFCON IV and that have been arguing for some time that the SEF mandate effectively forces them to open up their markets to the buy side, however much their traditional dealer client base might hate the idea. Now, it seems, interdealers will no longer be able to maintain a market solely for the benefit of dealers.

Given the liquidity and price discovery skills they demonstrate in swaps, IDBs could have a significant advantage over the D2C platforms in competing for buy-side market share. That said, as we discuss in our forthcoming report (due to publish on Thursday, Nov. 21), for which we spoke to 50 buy-side firms, IDBs still have a lot of work to do to get buy-side firms on board. More than one-third of the firms TABB Group spoke with said they had never even heard of an IDB.

The other big issue plaguing the world of SEFs is the challenge of pre-trade credit checks. Here the concern is around the ability of clearing brokers to stand up to trades on their clients’ behalf in the event of a trade rejection from a clearinghouse. Some have wondered why pre-trade credit checks are such a big deal for swaps; after all, if a futures transaction needs to be completed, the clearinghouse simply makes a margin call to the Futures Commission Merchant (FCM) that covers the funds on behalf of its clients – and that, in turn, recoups those funds from its clients at the end of the day or even the next day.

In swaps, clearinghouses have been given actual power to reject individual client transactions on a real-time basis if there is insufficient margin to cover the trade. The only way to prevent a clearinghouse rejection is if the clearing broker covers the position for its client. Given that swaps are still pretty large transactions and bring with them a substantial amount of risk, this is not something swaps clearing brokers are enthusiastic to do. They want to be sure that:

They can recoup the funds.

That they are compensated adequately for the service.

Currently, there is no guarantee in either regard. Again, as we discuss in our forthcoming report on swaps trading, Wall Street has collectively underpriced swaps clearing fees. That said, brokers are leery of introducing new fees such as intraday funding charges, for fear that buy-side firms will rotate them out of favor. Nonetheless, this issue of pre-trade credit checks is going to have to get resolved if SEF trading in swaps is going to be a success.

Related to the issue of pre-trade credit checks is the so-called “Void Ab Initio (from the beginning) Rule,” which states that if a swap fails to clear because of some clerical error or failure in communication systems between a clearinghouse and a SEF, then the two counterparties to the trade should be given the opportunity to decide whether they want to re-execute on the same terms, or back out of the transaction “from the beginning.”

Here the issue is that the market may have moved in the time that it takes for a trade resubmission. In this case, the “out of the money” trade counterparty will have no incentive to re-execute the transaction. In a disclosed market such as RFQ, backing out of a trade could look bad from a reputational standpoint; but in an anonymous market, there is no such risk. “Out of the money” counterparties will simply back out of losing trades at will, leaving the firm on what would have been the winning side to nurse its wounds.

Last, but by no means least, is the issue of Made Available to Trade (MAT), which is scheduled for determination in February. In his opening remarks at SEFCON IV, Chairman Gensler said he believes there is sufficient liquidity across the entire interest rate swap curve to support SEFs that want to make those swaps available for trading, indicating that the CFTC will not stand in the way of any SEF that wants to force products to trade on its platform.

At the end of October, after being the first SEF to formally submit its MAT application to the CFTC, Javelin SEF also became the first to alter its application, reducing the maturities and types of swaps it had claimed should qualify for MAT status. This is a sign that new entrant SEFs may show some restraint when it comes to MAT, perhaps out of fear of a buy-side boycott.

Again, as we discuss in our report, new entrant SEFs face a delicate balancing act as they compete for market share. On the one hand, there is an opportunity to force market change. On the other hand, they have to be careful not to anger the industry and find themselves struggling to attract support.