SEF-a-Palooza: Commenting on the Comments

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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.

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