The CFTC and the SEC somehow found time in the midst of writing derivatives reform regulation to make recommendations on how to prevent another flash crash. I don’t think anything in here was too surprising, although I do think that they’re banning too many things rather than creating rules that incent a change in behavior.
Kevin McPartland, a senior analyst with capital markets advisory firm TABB Group, has some concerns about the panel’s approach.
“They want to ban a lot of practices. If they ban a practice, the market will likely find another way to do what they need to do. It would make much more sense to try to create a market structure that incents certain behavior,” he says.
Read the full story at TheStreet.com
I’ve spent the better part of the last year studying what will become the swap execution facility (SEF) market, how it will be regulated, its players, its impact on derivatives trading. More recently I’ve had the pleasure of speaking with a number of the industry’s leaders in the space regarding the plans for their organizations and how they believe the final rules should look once passed by the SEC and the CFTC.
I thought it was worth a post to create a single view of these conversations and provide a resource to anyone else looking to understand the new SEF landscape. So (in no particular order) here they are:
Eris Futures – Neal Brady, CEO
ICAP – Chris Ferreri, Managing Director
eDeriv – Jason Yoon-Hendricks, Parter
TabbFORUM Derivatives Event Panel – CreditEx, Getco, UBS, Javelin, Eris Futures
There are several more firms and individuals out there that play an important part in the SEF debate, and I hope to have similar “on-air” conversations with each. Until then, enjoy.
This piece provides an overview of the derivatives reform related regulatory rule writing process, but a focus on the numbers. How much will it cost, how much (or little) are regulators spending on technology and just how big is this market.
“All the data will be reported to regulators to seek out systemically risky situations. But the reality is that the technology required to sift through all this data is out of reach of regulatory budgets,” says Tabb Group senior analyst Kevin McPartland. “Furthermore, just looking at the OTC derivatives of an institution won’t give regulators a full view of the underlying risks. They need to look at everything on the balance sheet.”
Read the full article at theDeal.com
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; katy.burne@dowjones.com
–Sarah N. Lynch contributed to this article. [ 12-09-10 1623ET ]
Despite the CFTC’s postponement of the SEF proposal release, debate still came on quickly as to their prescriptive approach surrounding trading model. These quotes are based on my commentary that we will publish early next week.
“With liquidity so thin, under this new model the simple presence of a quote will alert the rest of the market that someone has an interest in a certain contract,” says Mr McPartland.
“This type of information leakage will create a huge opportunity for others to game that order by trading in front of it which could potentially move the price against the quote requesting firm,” he says.
SeekingAlpha picked up my my recent quote in a Bloomberg article about proposed CCP ownership limits for dealers proposed by the CFTC. The author is right, I am flabbergasted.
Kevin McPartland is justifiably flabbergasted:
“What is an LCH.Clearnet going to do, that’s almost completely dealer-owned?” said Kevin McPartland, a senior analyst with Tabb Group in New York. “I can’t see how they’d expect that kind of massive divestiture of these clearinghouses that control trillions of notional” in swaps trades, he said.
Ah, but Kevin, you just haven’t fully grasped Gensler’s grandiosity (see above CDS position limit power grab). The sorcerer’s apprentices are run amok, my friend.
Read the full story at SeekingAlpha.com
The Lynch Amendment is back. The CFTC is expected to release its first set of proposed rules related to OTC derivatives reform this Friday and it is expected that those rules will include limits on dealer ownership of clearinghouses (among other things). I get the logic, but from what we know of the expected proposal this approach seems flawed:
“What is an LCH.Clearnet going to do, that’s almost completely dealer-owned?” said Kevin McPartland, a senior analyst with Tabb Group in New York. “I can’t see how they’d expect that kind of massive divestiture of these clearinghouses that control trillions of notional” in swaps trades, he said.
Read the full story at Bloomberg.com
Wall Street (which includes yours truly) was in Washington on Wednesday (Aug 15) to discuss Swap Execution Facilities with the Securities and Exchange Commission and the Commodity Futures Trading Commission.
I wasn’t the only one walking the block between Union Station, where the express train from New York arrives, to the SEC’s building. Walking in, my first thought was how can regulators complain about Goldman’s new building when theirs was just as new and (nearly) as shiny?
Esthetics aside, two panels focused on defining what a swap execution facility should be. The SEC sat on the left side of the U-shaped table and the CFTC on the right, with the panelists in the middle. The expected firms were present – independent platforms (MarketAxess, Tradeweb, Bloomberg), interdealer brokers (the Wholesale Markets Brokers Association, represented by Tradition), the futures exchanges (Chicago Mercantile Exchange and IntercontinentalExchange) and end users (PIMCO, et. al.).
There were some surprises. The Chicago Board Options Exchange was there. It took me a few minutes to figure out why, but their FLEX platform for trading bespoke equity options contracts could easily become an SEF. NASDAQ participated as well. Their motives are less clear. The only obvious link is their partial ownership of fledgling interest rate swap clearing house IDCG.
SEC Chairman Mary Shapiro sat in the front row as did CFTC Chairman Gary Gensler. Neither asked questions of the panelists directly, although Mr. Gensler couldn’t help but whisper into the ears of his staffers during the proceedings. The audience was a mix of dealers, IDBs, press and a high frequency trading firm or two. The SEC could have made things much more interesting by issuing visitor badges listing company names in addition to panelists’ names.
I learned a few things, though the arguments for and against each open issue were mostly restatements of ideas already aired. I will dig into these and other open issues in an upcoming research report, so stay tuned. The questions from the regulators – dominated by the CFTC – were thoughtful and focused in the right places; a stark difference from the early days of Congressional meetings in which one was often left wondering how well members of the legislature understood what a swap was.
Just over 300 days remain until these rules must be in place per Dodd-Frank. It is now abundantly clear that the OTC derivative execution landscape is going to change. Exactly what it will look like is still a good topic for debate (and a topic I will discuss in forthcoming research) but in this analyst’s opinion, we’re moving in the right direction.
The Impending CFTC SEF Proposal: What you need to know and why
Also posted at TabbForum.com
By opting for a prescriptive rather than a rules-based approach in regulating the OTC derivatives market, the CFTC is set to write the wrong prescription for swap execution facilities (SEF).
A major tenet of Dodd-Frank is to “promote pre-trade price transparency in the swaps market.” Through the rule-writing process, both the Commodity Futures Trading Commission and Securities and Exchange Commission are charged with pursuing this responsibility. By forcing additional transparency into the RFQ model and requiring the use of order-book trading, they are not only at risk of limiting pre-trade transparency growth, they would actually be reducing transparency and liquidity that have driven OTC derivative markets for years.
The details of these new SEF rules were expected on Dec. 8 but were postponed at the last minute by CFTC Chairman Garyt Gensler until this week.
Based on recent face-to-face TABB Group conversations with regulators in Washington, D.C., and ongoing discussions with market participants, CFTC officials apparently realized the proposal as is would have set off a firestorm and agreed to devote another week to discuss their proposal before going public. That was a good move.
The biggest issues deal with required order-book trading, the newly termed “transparent RFQ” and the generally prescriptive nature of the expected rules.
Let’s look first at the order-book model. TABB Group believes vanilla interest-rate swaps and vanilla CDSs will be the first to enjoy success with an order-driven market. Demand for these products is already growing, technology exists to make continuous two-sided quotes realistic and regulation will ensure an increase in market participants. In addition, major dealers have little reason to fight this move as only a small portion of profits come from trading in these flow products, whose spreads are already quite tight in comparison to more bespoke swap contracts. In fact, automation of the business could ultimately generate additional revenue rather than decrease it.
The proposal to force order book trading for instruments that trade more than 10 times a day could have some merit. Firms that favor order-book trading in a particular product would be incented to provide liquidity into the market to see volume hit the threshold. However, this proposal only becomes reasonable if the liquidity threshold is raised much higher. Assuming a 8:00 a.m. to 4 p.m. New York time trading day, one trade a minute would set the threshold just under 500 – a far cry from the proposed 10.
Taking this all into account however, it’s not the use of an order-book model in general that we disagree with. It is the required use of an order-book model.
Although market demand hasn’t moved us to an order book model in the past, the influx of new market participants changes the equation substantially going forward. Furthermore, a regulated electronic market place (aka, a SEF) will bring efficiency to the market regardless of its trading model. In addition, the required reporting of each trade will provide considerably more transparency into OTC derivative pricing than ever existed before – even if nothing else were to change.
The majority of OTC derivatives – including many so-called benchmark products set to fall under the order-book mandate – do not fit the above-stated mold. Requiring an order-book model is not going to increase liquidity and price transparency. Instead, it will force dealers/market makers to post artificially wide spreads to limit their trading risk, ultimately hurting the price-discovery process. The market will have less pre-trade price transparency because buy-side firms and other end users will need to call their broker to obtain the “real” price, as it will be well known that the posted prices are just a starting point.
Now the second point. A “transparent RFQ model” is defined as one in which quotes from dealers will be made available not only to the requester but to the market as a whole. The most liquid single-name CDS, for example, trades roughly 20 times per day. Most are traded much less frequently, often only a few times a week. With liquidity so thin, under this new model the simple presence of a quote will alert the rest of the market that someone has an interest in a certain contract. This type of information leakage will create a huge opportunity for others to legally game that order by trading in front of it, which could potentially move the price against the quote-requesting firm.
Furthermore, many firms will be reluctant to submit an RFQ, choosing instead to work through pricing on the telephone with their dealer and submitting the agreed trade to an SEF for booking. This too eliminates pre-trade price transparency.
Quote responses from dealers will also be impacted because they will be aware the quoted price will be seen by all rather than only the requesting firm. Although the intention of a “transparent RFQ” is to aid pre-trade transparency and prevent dealers from giving preferential pricing to one client over another, in this case it will ultimately hurt transparency in the market by moving price discovery off the screen.
The above notwithstanding, there’s a more fundamental question that must be asked surrounding changes to the RFQ model: It works, so why are we trying to fix it?
It is not a dealer conspiracy that regulators must rectify; it’s just the way the market works. And remember, the RFQ model had nothing to do with the credit crisis.
TABB Group believes the CFTC should stop short of designating how price discovery should occur. The commission should leave it to the market to decide which models work best in which situation. If the buy side wants to trade via an order book, for example, then it will naturally migrate to a platform that offers such functionality.
There is another paradox that must be brought to light. U.S. regulators are hell bent on curbing high-frequency trading, which they see as a detriment to the U.S. equity market. But why do those same regulators want to create a swaps market in which liquidity fragments and high speed trading is possible?
Case in point: SEC Chairman Mary Shapiro has said that the swaps market should work more like the equities market. Don’t get me wrong, I fully believe that competition, technology innovation and electronic trading are what have allowed the U.S. to keep its title of financial capital of the world. Regardless, I still implore regulators to pick a path and stick to it.
That paradox aside, I have little doubt the authors of the latest rules surrounding SEFs and the commissioners who voted for these rules have their hearts in the right place. On Wall Street, unfortunately, pure motives do not always make for sound decisions.
The market will not benefit from prescriptive rules surrounding trading models. Market demand and subsequent liquidity (or lack thereof) should dictate whether an instrument trades via RFQ or CLOB.
As for the RFQ model, enhancements are always possible; however, the current model has proven quite effective across a wide variety of asset classes and so moving to radically change the model could have drastic unintended consequences.
In sum, we need to move two steps forward, not two steps back. Change for the sake of change helps no one.