The Impending CFTC SEF Proposal: What you need to know and why

By | December 15, 2010

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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.

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