I can’t find a good link so here’s the story from Dow Jone’s Katy Burne. I think my best contribution is the last quote in the article. Enjoy.
(c) 2010 Dow Jones & Company, Inc.
NEW YORK (Dow Jones)–The Commodity Futures Trading Commission’s decision Thursday to delay a controversial vote on how over-the-counter derivatives should be executed once the Dodd-Frank financial-overhaul bill is enforced took many market participants by surprise.
Some speculated that in the hours leading up to the vote, CFTC Chairman Gary Gensler, a Democrat, received signals he wouldn’t get the support he was expecting from the four other CFTC commissioners. A majority is needed for any proposal to be published for public comment, and a second vote is needed for it to be implemented.
The proposal concerned a new class of trading platform called a “swap execution facility” brought about by the Dodd-Frank law. It would have required the vast majority of OTC derivatives to be traded on futures exchanges or the SEF alternative trading venues in an effort to improve pre-trade price transparency.
The four other CFTC commissioners are Republicans Jill Sommers and Scott O’Malia, and Democrats Bart Chilton and Michael Dunn. Dunn was thought to be the one with reservations, and O’Malia was thought to be opposed. When asked if he planned to vote against the proposal, Dunn declined to comment. Calls to O’Malia’s offices weren’t immediately returned.
In an interview with Dow Jones Newswires Thursday, Sommers said she wasn’t sure why the vote was delayed, but she was going to vote against the proposal because it was too narrow in scope.
“The Commodity Exchange Act defines a trading facility, but the new statute contemplates that SEFs could also be traded on systems or platforms, not just facilities,” she said. “By introducing these new undefined terms into this act, specifically regarding SEFs, it meant we should be looking at a broader model for executing swaps on SEFs than what exists in the futures world today,” Sommers said.
While the proposals released before the scheduled vote were in line with the commission’s earlier guidance, the details were thin and left undefined key terms that could force sweeping changes to the way derivatives are traded, potentially hurting liquidity in the $583 trillion market.
A CFTC spokesman declined to elaborate on the key sticking points behind the delay. The vote was pushed back to next Thursday along with other measures already scheduled for that day.
In an outline before the vote was delayed, the CFTC put forward three solutions that would dictate how swaps must be traded when the Dodd-Frank rules become effective in the second half of 2011.
In the first, swaps that trade with a certain frequency and “exhibit material transaction volume” would have to be executed on exchanges, which use “centralized limit order books” where live prices are made public and trades are executed on a screen for all participants to see.
In the second, swaps that trade less frequently, and that aren’t large enough to be market-moving trades called “block trades,” could be executed either on exchanges or what the commission terms “transparent request-for-quote” systems. Transparent RFQ systems would essentially involve prices being made public before a trade is executed to all participants, not just to the customer that requested the quote.
The third tier would cater to swaps that aren’t block trades, but are customized swaps that don’t trade frequently and wouldn’t be forced into mandatory processing by central clearinghouses. These trades could be executed in a multitude of ways: either by phone rather than on screen; on a request-for-quote SEF where the price is only visible to a limited number of dealers; on a more transparent version of the request-for-quote SEF with every participant seeing all quotes; or on exchange with full transparency.
Which bucket a trade falls into would depend on where the CFTC sets the barrier for what constitutes a block trade, and what it considers to be a trade of “material transaction size” based on average swap sizes lodged in industry data repositories. The most liquid credit default swaps insuring bonds tied to a single corporate-bond issuer trade only 20 times a day, for example, according to Depository Trust & Clearing Corp. data.
In Dec. 6 letter to the CFTC, electronic trading platform Tradeweb wrote that if the rules for SEFs are written too narrowly to make SEFs look like exchanges, they could force existing providers who could qualify as SEFs to unnecessarily change their business models. “The decision by the CFTC to continue debating the SEF rules reflects the importance and complexity of the issues facing the regulators,” said Lee Olesky, CEO of Tradeweb, in a statement Thursday.
The problem is that if dealers in OTC derivatives are required to post prices to all participants in the trading platform at the same time, even if not all participants can execute on those prices, dealers will adjust their prices to reflect the added risk associated with that information being in the public domain and to account for the costs of hedging out their own position.
With those artificial spreads in the market, swaps customers will end up calling a dealer to find out the real price, says Kevin McPartland, senior analyst at independent research firm TABB Group.
The first tier isn’t the issue: On standardized, relatively high-frequency trades, the margins are already thin so they would likely have migrated to exchanges anyway. Dealers call that business “flow” business.
The real battle ground is where the big money is–where quotes still allow for incumbent dealers to build in a profit, or spread, through the request-for-quotes system. According to research from the Swaps and Derivatives Market Association, an industry trade group advocating for derivatives reform, dealers make $60 billion annually from interest-rate swaps and credit derivatives alone by keeping prices private.
“RFQ works, so why are we trying to fix it?” asked McPartland. “It’s not a dealer conspiracy that regulators must rectify; it’s just the way the market works. And the RFQ model had nothing to do with the credit crisis,” he said.
-By Katy Burne, Dow Jones Newswires; 212-416-3084; firstname.lastname@example.org
–Sarah N. Lynch contributed to this article. [ 12-09-10 1623ET ]