It seemed like the CFTC’s meeting yesterday (Dec 12th) would be a
big one; we’d find out the size of a block trade and in doing so get some insight into how truly electronic the swaps market would become.  Unfortunately, the can has been kicked down the road again.  Instead we have a seemingly temporary 30 minute reporting delay for all trades (until block trades are defined) and confirmation that all trades must be reported (a no brainer).
My comments in the Wall Street Journal could have used a little qualifying, as they sound a bit generic out of context (of course market data exists today), but if you’ve read any of my other research you know where I’m coming from. Â Here’s to hoping this market actually can get moving in 2012.
Swaps market analyst Kevin McPartland, a principal with research-firm TABB Group, said the new rules will greatly increase amount of available data on each trade. “We’re going from a world where there was almost no market data to a world where it will be regulated into existence,” Mr. McPartland said, adding that now “everyone will have streaming data on these markets.” He estimates that the Dodd-Frank derivatives regulations will cost the industry $1.8 billion in total but hasn’t separated out the cost for the data rules.
Read the full story here:Â http://on.wsj.com/tszLKA
On Tuesday, December 13th I presented to the CFTC Technology Advisory Committee. Chairman Gensler and Commissioners O’Malia and Wetjan were all there. Each panelist, myself included, gave a 15 minute opening and then we participated in an open Q&A with the Chairman, Commissioners and the members of the TAC.
Maybe I’m just optimistic, but it felt like we actually got somewhere. Chairmen Gensler probed me on the number of SEFs, the importance to dealers of building electronic connectivity to clients and the impact smaller order sizes will have on clearing costs. The other big topics of the morning were order interaction rules and the 15 second rule (which no one but the Chairman seems to support).
The biggest policy question I came out of the meeting asking was will the order interaction rules – requiring the RFQ and order book parts of a SEF to interact – be proposed and passed. I suspect they will still be proposed, but with language that makes using the linkage optional for users. More on this in the coming weeks.
And on a slightly related note, the CFTC just released its proposal defining “made available for trading.” Defining this turn is a pretty critical part in determining how electronic and liquid the post-DFA swaps market will become.
My opening starts about 24 minutes in. Enjoy.
A few weeks ago I had the privilege of sitting down with CFTC Commissioner O’Malia. In this clip, we talk about how important technology is to both participating in and overseeing the swaps market and financial markets as a whole.
Another article looking at the new proposed margin rules from the FDIC and CFTC. The debate here is if end-users, say Exxon, could start marketing swaps to hedgers and compete with the banks as they won’t have to comply with the new margin rules as an end-user. I argue that as soon as they start trying to get into the market making business, they’re no longer an end-user and should be classified a dealer making the point moot.
Not sure what my quote says is obvious in the context it was used, but basically bank lobbyists will never let end-users get away with making markets without being classified as a major swap participant or dealer. The loophole is just too big. There are a number of other issues at play here too, and this article does a good job of stepping through them.
“It will come back to these firms losing their ability to call themselves end-users based on their trading practices. The bank lobbyists will never let this fly,” said Kevin McPartland from TABB Group.
Read the full story at Reuters.com
First, I’d like to thank Commissioner O’Malia and his staff for inviting us here today for what is shaping up to be a very informative day.
I’m Kevin McPartland, Head of Rates and Credit Research at TABB Group. We are an independent research and advisory firm focused solely on the institutional capital markets.
Everyone finally agrees on something. Swap Execution Facilities are good for the market. Based on a soon-to-be-published TABB Group poll of more than 140 market participants, 87 percent believe the creation of swap execution facilities will ultimately be good for the swaps market. Of course everyone defines “good” differently, but nevertheless, this demonstrates how the market now sees that nearly every business model can – and most will – be adapted effectively to work under the proposed SEF rules.
That being said, no solution will satisfy all market participants — nor should it. Regulators should not try to appease everyone in the market but instead focus their efforts on creating a set of rules that work.
We must think back to the early days of financial reform to remember why these rules are being written in the first place -– to reduce systemic risk. According to the same TABB Group study, only 60 percent of the market believes the proposed rules will do so as written. The 40 percent who think otherwise are not simply naysayers in one corner of the swaps market either – they span the entire spectrum from swaps dealer to asset manager to SEF.
So while we debate whether RFQs must be sent to one trader or five and whether or not the proposed block trade size is too big or too small, we must remember to think big picture. Whether or not an RFQ goes to two dealers or five has no impact on whether or not another bank will fail. The rules should not be written to solve a political problem or appease a certain set of market participants – but instead to create a market structure that reduces systemic risk while increasing liquidity and encouraging competition and innovation.
I look forward to discussing these issues and others in more depth over the next few hours and hearing how the soon-to-be swap execution facilities will help us meet these goals.
Apparently FTSE thought I had something interesting to say on this topic, as they put my picture front and center in this article (not that I’m complaining). Magazine layout aside, as the CFTC has pumped out rule proposals through the fall and winter, the industry has told them to slow down and the CFTC is now saying they can never get it all done by the deadline in July 2011 even if they wanted to. Part of this falls on “you can’t rush a good thing”. The best rules would be ones created from a slow and steady approach. But the real problem here is the CFTC just has no money. No money means not enough people and (as Commissioner O’Malia has pointed out a lot lately) not enough technology.
Also posted at TabbFORUM.com
Washington and Wall Street get to tick off another box on their march toward creation of Swap Execution Facilities (SEF). Dodd-Frank passed on July 21, 2010, the Commodity Futures Trading Commission proposed its SEF rules on Jan. 7, 2011, and on March 8, 2011 the comment period closed. For those of you keeping track at home that’s a total of 230 days elapsed.
This milestone is important because in theory the CFTC should now have all the information it needs to finalize a rule that at least a (Democratic) majority of the commissioners can agree on in a vote this summer. I say in theory because it should come as no surprise that the information gathering will certainly continue right up to the last minute. Lobbying efforts will never – and I mean never – cease and at least a few information gathering meetings are scheduled for the spring. The most interesting of which has been referred to by a participant as SEF-a-palooza.
As I write, only 10 comments have been filed with the CFTC. I suspect, however, that by the time you’re reading this article, many more comment letters will have come in just under the deadline. You can check out the most up-to-date list here. The big issues seem to be with the block trade rule, the rule requiring that RFQs must be sent to at least five market participants and the definition of “made available for trading.”
Block Trades
The block trade rule is described in the CFTC’s proposal entitled “Real Time Public Reporting of Swaps Transaction Data.” Why does this matter to SEFs? In short, block trades are exempt from the SEF trading requirement, which means these transactions can occur over the phone as they do today. Reporting will still be required and the clearing mandate will still apply, but reporting will be delayed and pre-trade price transparency would not be required on the screen. From that you can understand why many market participants want as many trades classified as block trades as possible.
According to the aforementioned “Public Reporting” proposal, a block trade is defined as: “The minimum threshold shall be a notional or principal amount that is greater than 95% of the notional or principal transaction sizes in a swap instrument during the applicable period of time…” There is a lot more detail in the proposal but 95% is the key number. The thought from commenters is that this percentage should be much lower and I can understand why.
Let’s say it’s set to 50%, meaning that a trade is a block if its notional size is half of the average notional traded in a week (or day, or month). Could you imagine the impact of a trade in the futures market that was 50% of the average weekly notional? We don’t really need to imagine – it’s called the flash crash. I will not pretend to have an answer – but the key message is that information leakage is a big concern when it comes to swaps trading and reporting, and the definition of block trade is a big piece of solving that puzzle.
The RFQ Debate Rages On
When the CFTC SEF proposal was issued, most of the industry cheered as they would not be forced to use an order book, and the “transparency RFQ” model would not come to be. But of course, there was still something to complain about (sorry, I’m getting a little cynical). The CFTC requires RFQs be sent to “at least five potential counterparties.”
The complaint with this requirement goes back to the same root as the issues with the block trade requirement. For thinly-traded contracts, asking five or more dealers for a quote is like posting a neon sign on the front of your building to tell the world what you’re trading and why you’re trading it.
The Securities and Exchange Commission seems to agree. Their SEF proposal, released in early February, requires RFQs to be sent to a number equal to or “less than all participants,” which to me reads as more than one. This fits neatly with Dodd-Frank’s requirement that SEFs be many-to-many trading venues.
If I had to make a prediction, I’d say the CFTC will back off of the “five” requirement and change the language to read more than one. The industry will still argue that in some cases they only want to ask their one favorite broker for a price, but compromise is required to make a marriage work.
After-Hours Trading
To recap, three criteria must be met before a swap can be mandated for trading on a SEF (or DCM, to be technically accurate). The swap must be: (1) “Subject to the mandatory clearing requirement, (2) ‘‘made available for trading’’ on a SEF and (3) “too small to be a block trade…” What must be cleared we’ve debated in other posts and I’ve just covered the block trade requirement above. That leaves us with “made available for trading.”
The phrase falls into the list of mildly ambiguous regulatory language that gets lawyers excited because they can argue it means almost anything they want. The CFTC SEF proposal explains that SEFs must conduct annual reviews (because new products are only created once a year) and that they can use criteria such as “frequency of transactions…open interest, and any additional factors requested by the commission.”
The rub here is not about the review period or criteria to determine if a contract should be made available for trading but the fact that technology allows a SEF to very quickly add a new instrument to its database and have it immediately available for trading even in cases where liquidity is nearly non-existent. For the few trades that are done in said contract, this interpretation of the rule guarantees the listing SEF (or SEFs) can generate revenue from any currently OTC product almost at will.
Good for them, bad for dealers who help clients execute complex, illiquid contracts.
I’m not crying for the dealers, but in practice the determination should be more in depth than the existence of a database entry within a SEF trading platform. Forgetting about liquidity issues and SEFs grabbing OTC business for a second, it’s unrealistic to expect the market to suddenly flip a switch on a given contract when a SEF decides to “list” it. I can see it now – a memo goes out at 8 a.m. that Swap XYZ is now available for trading, so you better not dare pick up the phone to trade it starting today.
I’m crazy to keep making predictions, but I’d say the way forward here is with quarterly reviews, a defined set of criteria for “available for trading” and an implementation time for a month or two for each product that is newly “listed” to the market can make the change.
The Best for Last
I’ve left the best part for last. Of all the suggestions in all the comment letters sent to the CFTC over the past year, I think this one is my favorite. Morgan Stanley is proposing that SEFs should be required to set trading hours for their platforms, similar to the hours set for trading on the floor of the New York Stock Exchange, for example. That doesn’t sound as crazy as you might think. Surely traders need to go home to their families and trading systems need maintenance overnight.
Not so. CME’s Globex is open 23-½ hours a day as its user base spans the world. Not to mention many of the “traders” interacting with Globex are related to IBM’s Watson and so need no sleep. But that’s not even the interesting part of the Morgan Stanley proposal.
The firm goes on to suggest that with trading hours in place, any trading that needs to be done outside of the set trading hours can be done OTC just like today. Would be interesting to see if a flurry of orders happen to execute at 4:01 p.m. New York time when the swaps market “closes.”
The bottom line is that everyone needs to compromise. The way this market works should and will change but the CFTC also needs to be realistic as to the complexities of the global swaps market. I look forward to the final passed proposal this summer so we can finally stop debating what the rules should be and instead start discussing what the rules are and what they mean.
More on the SEC-CFTC flash crash recommendations. In short, they’ll force platforms that do not publicly display price quotes to execute orders better than the midpoint, or otherwise route them out. This would kill the business model for many registered ATS’s. The goal of greater transparency is good – but the unintended consequences are huge. To me sounds like trying to fix something that isn’t broken, but many disagree.
Heavy-handed enforcement of rules that challenge business models could prove counter-productive, adds Kevin McPartland, senior analyst at research firm TABB Group. “They motivate firms to change their behaviour rather than out-right banning practices,” he said. “The more that they ban, the more it will force the market to work out ways to run strategies or manage risk in a way that would mimic what they were doing before.”
Read the full story at TheTradeNews.com
Determining if SEF Aggregation Really Matters
This post also published at TabbFORUM.com
Regulations will have a significant impact on how SEF aggregators function and how widely these aggregators will be adopted by various market participants. Some of the most contentious rule proposals are those that will have the greatest impact on liquidity fragmentation. They include the 15-second rule, the ability to voice trade, the “block trade” definition, best execution requirements, and
the requirement to send an RFQ to five dealers. The Smart Automated Agency Broker (SAAB), think swaps smart order router on steroids, will not only help traders execute the right product at the right price, but it will also mitigate regulatory complexities.
Much of the complexity has to do with the regulators’ goal of increasing transparency in the market. The thing we have to remember is, market participants are hypocritical when it comes to transparency: They want to get transparency, but don’t want to give it in return. While regulators work to pass rules that increase pre-trade and post-trade reporting, the market will push to ensure simultaneous regulatory compliance and trading anonymity via smart and flexible technology.
The Rules of Engagement
There are those at the CFTC who dislike voice trading on a SEF because they believe it limits the market’s ability to see all available bids and offers on the screen in real time. Because most swaps products are fraught with complexities and trade with relative infrequency, however, being able to speak to a broker directly about market pricing remains a necessity.
By way of compromising with the industry the CFTC has instituted what has come to be known as the “15-second rule.” It states that two parties may prearrange an order over the phone, but the order must then be displayed on the open market for 15 seconds. This communicates to the market the intentions of both the buyer and seller, which then creates an easy opportunity to trade ahead of the order. The 15-second rule also allows other market participants to price improve the original arrangement which, in theory, could benefit the buyer.
What does this have to do with liquidity fragmentation? The information leakage created by displaying a prearranged order to the market for 15 seconds is like a football coach giving his playbook to the opposing team a week before the big game. To prevent counterparties from being taken advantage of, large orders will need to be sliced and diced then sprayed across the relevant SEFs-something only a SAAB could do effectively. A firm having to protect its information in this way accounts for much of the swaps market’s expected increase in transaction volume. The percentage of transaction volume that the 15-second rule will impact will largely be determined by the proposed block trade rules.
Both the CFTC and SEC have proposed rules that define the size of a block trade, and allow block trades to be reported to the market after 15 minutes (rather than “as soon as technologically possible”). Treating a block trade differently than smaller orders is common in regulated markets. What’s of concern to us isn’t that block trades exist, but how they are defined.
The swaps market is a block-trade market by definition (the average interest rate swap is $129 million). The recent CFTC block trade rule defines roughly one third of the market as block trades (the details of this rule are explained well in another TabbFORUM post). Conversations with various market participants have left me to believe that the current rule is much more reasonable than the original proposal which would have seen only 5% of the market defined as a block. However, assuming that an interest rate swap block trade will be roughly $250 million or higher, a large swath of traders concerned with execution anonymity that routinely trade IRS sized between $100-200 million will quickly realize the only way to do that size without create a market stir is via a SAAB.
The 5 RFQ requirement and order interaction rules will not cause fragmented markets, but they will impact how the SAAB functions. The CFTC’s “5 RFQ” rule requires that all RFQs be sent to at least five different liquidity providers. The SEC has countered with a proposal that RFQs must be sent to “one or more” liquidity providers. TABB Group believes the CFTC will lower the number of liquidity providers that must be contacted from five to two. Still, the SAAB would need to know the relevant regulator for each product and act accordingly. This is most critical for credit traders, as index CDSs fall under the CFTC’s rules, and single-name CDSs, the SEC’s.
SEF best execution rules, more formally known as order interaction rules, will require SEFs to force interaction between their RFQs and CLOBs. Before a RFQ can be acted upon, for example, any better-priced liquidity in the order book would need to be taken out. The SEC has proposed such rules and the CFTC continues to contemplate a similar approach. TABB Group believes this rule is unnecessary. Market participants all have a fiduciary responsibility, whether to their investors, shareholders or brokerage clients, to execute in the most efficient way possible. Furthermore, whether mandated or not, SAABs will take into account all market prices when determining where to trade, regardless of market model. It’s like mandating that we drink coffee in the morning: It’s going to happen anyway, so why bother mandating it?
As a side note, technology can and will help market participants deal with these differences between SEC and CFTC rules; technology might also provide opportunities for those looking to benefit from the rule differences. But this begs the question: If the industry will simply work around the rule differences anyway, wouldn’t it be easier on everyone if there were no rule differences?
Don’t Tell Anyone I’m Here
Buy-side traders will also look to minimize the market impact of their trading in other ways. Sponsored access, as it is known in equity markets, is when a broker allows a client to trade directly on an exchange using the broker’s exchange membership. The broker is still responsible for the orders that go down to the exchange, and so must have pre-trade risk procedures in place, but the client can self-direct trades without any manual interaction from the broker.
CFTC rules allow direct access to SEFs without any broker involvement, but this direct access is only part of the allure of sponsored access in equities markets. Sponsored access also allows the client to trade under cover of the broker’s name, which leaves the market unaware of who is actually doing the trade. This “service,” if it is offered for swaps trading, could be a boon for dealers because it would encourage even large hedge funds to trade through a broker rather than accessing the market directly. The success of swaps sponsored access is inversely proportional to the success of SEFs that offer anonymous trading, because the latter would severely limit the need for the former.
Even if sponsored access becomes common, brokers would still not be able to execute a trade on a SEF and then move that position to their clients’ accounts (commonly referred to as the Principal-Principal model). “Moving” the original trade would be a trade in and of itself. This second trade would then fall under trading mandates, which means that the trade would have to be exposed to the SEF (via the 15-second rule) before it could be executed. That, of course, would generate additional risk and cost to both the client and dealer, making the approach less than desirable.
Direct market access for clients also provides further support for the agency model, and its use of the SAAB. Since brokers cannot profit by taking principal risk, they will instead charge fees for use of their trading tools and physical market access. TABB Group believes the market will ultimately adopt this model. This also brings us to the single dealer portal (SDP).
SDP to SAAB
Therefore, many SDPs are in the process of converting their swap-trading screens to SEF aggregators and SAABs (see Exhibit 1). These conversions are most prevalent among fixed-income platforms focused on CDS and interest rate swaps trading. TABB Group has also seen evidence that platforms that are currently focused on other areas, such as spot FX or US Treasuries, plan to build SEF aggregators to build up rather than dismantle their SDPs. By providing their clients with these new liquidity-seeking tools, dealers can try to maintain the screen real estate and relationships they have spent years establishing, even though those clients will be able to trade directly on SEFs themselves.
Under proposed regulations, dealers will not be able to fully own and operate SEFs. This means that SDPs, those that now act as primary sources of liquidity for the buy side, cannot register as SEFs unless owning dealers were to sell off most of their businesses.
This all sounds like a win-win, doesn’t it? Clients get trading tools to reduce the complexity of execution at virtually no extra cost, and dealers can still utilize the SDPs in which they have invested so much. Unfortunately, it might not be that easy. A number of questions still linger as to the regulatory requirements and mechanics of dealers offering such a toolset.
Regulators are working to determine if they should require SEF aggregators to comply with the same kinds of rules with which SEFs must comply. If SEF aggregators provide clients with pre-trade price transparency-one of the core goals of Dodd-Frank-ensuring they do that fairly and consistently is critically important. Based on TABB Group’s conversations with regulators, this additional regulatory burden seems unlikely because nearly everything SEFs do will already be heavily regulated. Besides, several other markets, including equities, futures, options and FX have liquidity aggregators and, to date, regulators haven’t put further oversight in place on any of them.
This post was taken in large part from my research report “Swaps Liquidity Aggregation: Best Execution to Product Selection”