SEF or OTF: A comparison of swaps trading reform in the US and Europe

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Is the sport called soccer or football? Should swaps be traded on Swap Execution Facilities (SEF) or Organized Trading Facilities (OTF)? For that matter, should organized be spelled with a ‘z’ or an ‘s’? While some of these debates are as old as the U.S. Declaration of Independence and others brand new, they highlight differences between how Europeans and Americans approach the rules. The real question however, is do these differences matter?

The G20 agreed that regulated trading venues are good, and we should push as much of the over-the-counter derivatives market on to those platforms as possible. Not just traditional exchanges but essentially any trading platform (preferably an electronic one) regulated by the local regulatory authority. The U.S. put its money where its mouth is and included in the Dodd-Frank Act language that requires exactly that: “With respect to transactions involving swaps subject to the clearing requirement … counterparties shall … execute the transaction on a board of trade designated as a contract market … or … execute the transaction on a swap execution facility…”

Interestingly, the European Commission’s (EC) proposal on OTC derivatives lacked the so-called trading requirement. Anything that can be cleared must be cleared; all OTC derivative transactions must be reported. Trading, it seemed, was not viewed in Europe as important to reducing systemic risk. The greatest fear of major U.S. banks apparently had come true even after their months of lobbying – with U.S. laws much more stringent than those in Europe, swaps trading was leaving for London and we’d all have to go with it or find another line of work.

Enter the MiFID Review. Remember the original MiFID? The Markets in Financial Instruments Directive is what allowed new trading venues, called multi-lateral trading facilities (MTF), to pop up all over Europe and wrestle market share away from the incumbent equity exchanges. The likes of BATS, Chi-X and other new pan-European venues ultimately drove the once dominant LSE into a marriage with the Toronto-based TMX Group and encouraged Deutsche Börse and NYSE Euronext to merge.

A review of MiFID was always planned for a few years after the initial implementation.  Furthermore, MiFID was always intended to cover much more than the equity market – hence the “Financial Instruments” in the title. But it goes without saying a lot has changed since MiFID was first approved in 2007 and the result is a much shorter timeline and a proposal that brings about more sweeping front-to-back reform across a much broader list of asset classes including, of course, the trading of OTC derivatives.

So it turns out that Europe will likely have a swaps trading requirement after all. More precisely: “the MiFID framework directive could be amended to require all trading in derivatives which are eligible for clearing and sufficiently liquid to move either to regulated markets, MTFs, or a specific sub-regime of organised trading facilities…

With that statement we see that the U.S. and Europe are going down similar paths. But as with all things as complex as the swaps market, different – albeit equally intelligent – people will undoubtedly find different solutions to the same problem. That takes us back to my original question: Do these differences matter?

How to trade

U.S. regulators have come to agree that dictating the exact method by which swaps must be traded on a SEF is not a good idea. A lightly disseminated draft proposal from the Commodity Futures Trading Commission included a requirement that the most liquid swaps contracts needed to trade in a central limit order book – an attempt to mimic the current approach used for exchanged-traded products everywhere in the world. Thankfully this requirement was removed from the official release a week later.

The International Organization of Securities Commissions (IOSCO) recently published its views on how the use of regulated traded platforms will impact the swaps market and their findings matched the decision made by the CFTC agreeing that “a flexible approach to defining what constitutes an organized platform for derivatives trading” was in everyone’s best interest.

MiFID II takes a similar stance on trading style requiring only that venues “have dedicated systems or facilities in place for the execution of trades.” But in this case, the devil is very much in the details. In an attempt to support the G20’s request for transparency, the MiFID II proposal goes on to state that venues “would be required to make its quote both in terms of price and volume available to the public.” In practice this would require RFQ responses to be made public – also known as the transparent RFQ.

It sounds sensible, but with that model the mere presence of a price quote for an instrument that may only trade once a week will alert the market that someone is trading in that particular instrument. This awareness opens the door for aggressive firms to use that information to trade against the firm that initially requested the quote.

A gaping hole for gaming the market is not a good way to kick-off a new regulatory regime.  Transparency is good; liquidity-killing information leakage is not.

Promote or Require?

That brings us to another difference in approach – the need for pre-trade and post-trade transparency. Post-trade transparency sees limited debate. Concerns exist around how quickly a trade must be reported and exactly what details must be reported, but by and large post-trade reporting is common across nearly every regulated financial market and no one expects the swaps market to evade that requirement.

The EC and the CFTC both like pre-trade price transparency as well, but what they expect of the swap venues in this regard is different. The CFTC states that a SEF must “promote” pre-trade price transparency whereas MiFID II would “require pre- and post-trade transparency for all trades in specific nonequity products, whether executed on regulated markets, MTFs, organised trading facilities or OTC.”

Requiring rather than promoting pre-trade transparency leaves many market participants uneasy. In liquid exchange-traded markets, pre-trade price transparency comes naturally as a side effect of the order book model. Since market makers are always posting prices to the screen (in many cases they are obligated to do this) it is possible for a potential buyer or seller of that instrument to get an idea of the current market price for the instrument before deciding to interact with the market. In traditional OTC markets and RFQ markets, it’s not so easy.

The swaps markets these rules are intended to reform are relatively illiquid, with some instruments trading only a few times a day, or even a few times a month. The only way to get the current market price is to value it yourself (which may not reflect what others are willing to pay) or ask someone. Asking for a price, via the phone, an RFQ platform or some similar method, constitutes interacting with the market which in turn may tip off the market that you’re up to something. As we already discussed, that’s information leakage.

Because of this distinction, mandatory pre-trade price transparency would undoubtedly drive the use of the order book model even in places where it wasn’t suitable for the liquidity profile of the product. Forcing the use of an order book model would then require dealers to post continuous two-sided quotes. For dealers to safely post two-sided quotes, they would need to keep spreads artificially wide; it’s the only way to limit their downside risk as a market maker. Artificially wide spreads mean that for a trade to be done, a phone call would still be required to get the “real” price. Even if quotes posted to an SEF had to be firm, no one would execute there because they would know that a better price exists under the covers. That being the case, even with an order book model, pre-trade transparency doesn’t really exist as the posted prices create only a range, not the current market price.

The point is that pre-trade price transparency can be very helpful to growing a market but it’s not always possible. By all means we should promote it, but it’s in no one’s best interest to require it.

When will this be settled?

I’ve only scratched the surface. The U.S. and Europe are following the same guidelines – those put forth by the G20 – as they work to reform the OTC derivatives market but we can’t expect the end result to be identical. There is good historical precedent for this: The original MiFID in Europe and Reg NMS in the U.S. had similar goals – to increase competition in the equity markets. On both sides of the Atlantic that’s exactly what we got, but the approaches were very different. For example, Reg NMS spelled out what best execution meant with a focus on price and MiFID left it up to the market participants. These and other differences didn’t drive New Yorkers to London or the French to Chicago, and neither will the differences in the U.S. and European approaches to OTC derivatives.

Unfortunately this won’t be settled for some time. The U.S. will have its final rules in July but the implementation periods for those rules will likely span years as phased in approaches are a must considering the size of the market and the scale of the change. Europe is a bit behind the U.S., but not as far behind as many believe. By the time U.S. rules are really up and running in mid-2012, the European markets will have some closure to their rules.

It would be nice if the U.S. and Europe could agree on a single label for swaps trading venues – it would make the topic much easier to discuss – but that’s unlikely.

If football doesn’t even translate, that leaves little hope for SEF. OTF, MTF or maybe even STF are the likely candidates. But I digress – over the next few years we all have much bigger fish to fry than the name.

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