Tuesday, January 31, 2012

Swap Execution Facilities*

Regulatory bodies on both sides of the Atlantic will be busy in 2012 finalising rules on one of the most important requirements for bringing pre- and post-trade transparency to the over-the-counter derivatives markets by ensuring prices are posted to a wide variety of market participants, not just among dealers. Initially set by the G-20 leaders at their Pittsburgh Summit in September 2009 and later adopted in reform packages in the US and Europe, transparency would be achieved through the requirements that “all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.

For this purpose, the Dodd-Frank Act in the US introduced a new trading venue called a swap execution facility (SEF), where only standardised swaps will be traded. The Dodd-Frank Act defines a SEF as "a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce." SEFs are similar to multilateral trading facilities (MTFs) in European markets. In addition to MTFs, the European Commission also introduced a new trading venue category (“organised trading facility – OTF”) to cover hybrid platforms run by firms which currently do not fall under the current MiFID categories for organised trading.

Although the general details of these facilities and how they are going to function have already been proposed, final rules will emerge later in 2012. However, there are certain differences between regulators in the interpretation of swap execution facilities. For example, as opposed to the strict CFTC proposal that swap execution facilities be either order-book or request-for-quotes (RFQs) from a minimum of five possible seller facilities, the SEC has proposed a looser definition of these platforms, which do not require order-books and would allow buyers to request a quote from a single seller.

Furthermore, the SEC proposal allows for voice broking, rather than stipulating electronic trading as the CFTC has. However, the US House Committee on Financial Services approved legislation (H.R. 2586) in late November 2011 which would prevent the CFTC from imposing a requirement that swap-buyers seek quotes from at least five participants before executing a trade. On 23 December 2011, the US House Committee Agriculture granted an extension for further consideration by 1 February 2012. We expect the CFTC final rule to be similar to one that SEC has already proposed, including keeping voice broking.

On 5 December 2011, the CFTC proposed further rules establishing a process for designated contract markets (DCMs) and SEFs to make swaps "available to trade" without  defining swap. The proposal calls for DCMs and SEFs to submit to the CFTC a determination that a swap is available to trade. To make a swap available for trading under the proposed rules, DCMs and SEFs must consider:
·   The readiness and availability of buyers and sellers of the swap.
·   The frequency and size of transactions in the swap on that DCM or SEF, or of     bilateral transactions in the swap.
·   The trading volume for the swap on that DCM or SEF, or of bilateral transactions in the swap.
·    The bid/ask spread for the swap.
·    The usual number of resting firm or indicative bids and offers that the DCM or SEF receives in the particular swap being considered.
·    Whether the DCM's or SEF's trading facility or platform will support trading in the swap.
·    Any other relevant factors.
A determination of which swaps would be made available to trade might be a challenging task both for regulators and trading facilities. As mentioned in previous OMRs, the OTC market is different from the futures markets. Instruments (swaps) in the OTC markets can trade infrequently, often in significant sizes,between dealers and end-users or speculators. If activity in the futures markets is any evidence, a relatively small number of highly liquid instruments has been effectively traded on the exchange. The failure rate especially in less liquid instruments has been very high. However, a lighter SEC proposal might be the proper way to bring transparency, while ensuring continued liquidity in the swap markets.
Some market participants raised concern over excessive fragmentation of markets with the introduction of different trading venues. For example, the purpose of introduction of OTFs, which can be considered a subcategory of MTFs, in the European Union is not well understood, except as creating further market fragmentation. Opacity in terms of unknown counterparties attracted by a shift towards electronic trading, as well as excessive fragmentation of markets, is actually a source of less, and not more, transparency in the market.
Market participants also argue that OTC markets are for professionals; not for retail investors. The role of brokers is primary in providing transparency. A move to a platform-based trading systems with a view to pre-trade transparency, actually removes transparency for the professionals that are involved.
A final criticism of moving swaps onto platforms is related to the claim that electronic trading is associated with higher volumes and volatility of trading. Critics argue that markets could be subject to the kind of volatility evident in the futures markets immediately after the introduction of electronic trading to the NYMEX and ICE exchanges. It is true that the volume of trading increased after moving from open outcry to electronic trading. However, there is no empirical evidence supporting the claim of increased volatility due to electronic trading.

*IEA Oil Market Report-January 2012

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