David Weiss, an independent research analyst and consultant, offers his take on how regulatory reform is evolving with regards to recent proposals for use of swaps execution facilities and central clearing of OTC derivatives.
Amongst the many things that the 111th US Congress sought with the passage and signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act was the transformation of OTC derivatives markets into something more closely resembling mature listed markets, principally through the enforcement of clearing on central counterparty (CCP) facilities and, when clearable in such a manner, trading on swaps execution facilities (SEF) or even exchanges. While over 800 pages in length, this legislation left the details up to the CFTC and SEC, remarkably giving them just 360 days to write all the regulations (not just on CCPs and SEFs). On January 7, 2011, just about halfway there, the CFTC published its proposed regulations on SEFs for public comment. The SEC is scheduled to issue its proposals security-based SEFs sometime between January and March 2011.
This compressed timeframe stands in stark contrast to those of the evolution of relatively simple cash markets. For example, in cash equities it took close to a decade of electronification via FIX and regulation via Reg ATS, culminating with Reg NMS just a few years ago, to bring relative order to the OTC trading of these (already standardized) listed securities. As well, it took many years for off-exchange trade internalization to evolve into the plethora of ECNs, ATSs, dark pools, etc. (only in the last few years some registering as full-blown exchanges) that many legislators and regulators view as the model for SEFs. Moreover, these OTC cash markets, in addition to being simpler, already had established CCPs, whereas many of today’s OTC derivatives markets are either not clearable at all on any CCP or have many nonstandard trades that can’t be handled by CCPs.
The regulations promulgated by Dodd-Frank will first enforce the clearing of all “standardized” OTC derivative trades on either existing or newly formed CCPs, and only after that enforce OTC derivatives trading onto SEFs. However, while the enforcement of CCP usage is practically mandatory, SEF usage is enforced only if a SEF exists to handle an OTC derivatives market and the particular instrument is available to trade… if not bilateral trading in its current form may continue as there is no enforcement for a SEF to be formed. While there is little doubt that SEFs will quickly arise for CDS and IRS products (e.g., Tradeweb has already announced its intention to register as a SEF), the horizon for less liquid OTC derivatives products is not so clear. The evolution of transparency in most OTC derivatives markets has mainly followed slow transformation from pure manual voice to semi-electronified hybrid markets as liquidity increases:
– electronic pre-trade price discovery
– single-dealer RFQ systems
– electronic RFQ aggregation and trading platforms
– electronic confirmation services
– trade repositories
with CCPs coming last (e.g., NYSE Euronext’s Bclear went live as the first to clear CDS in December, 2008). Regulatory focus on CCPs first turns this evolution upside down.
One may argue that it is dissatisfaction with the evolution of OTC derivatives markets, or lack thereof, and the havoc caused by their opacity, which has led to legislative and regulatory initiatives upending rather than accelerating their evolution. It’s another matter entirely whether these initiatives will succeed in achieving their desired outcomes. There are numerous instances where established players in these markets have created financial products or electronic platforms that have failed to attract liquidity, flow, or traction (e.g., NYSE Euronext shut down CDS on Bclear in mid-2009 after failing to attract trade flow, though Bclear had been successful previously in OTC equity derivatives)… if you build it they will not necessarily come. If derivatives were easy everybody would be doing them, but as relatively complicated products in opaque OTC markets, many OTC derivatives are not easily and clearly understood by established participants in the underlying cash markets let alone by today’s legislators and regulators… even with the best intentions, if you regulate it so won’t necessarily make it so.
In watching the CFTC’s public roundtables and hearings on SEFs, it’s clear that the lead staff and commissioners are still learning about OTC derivatives market structure and trading practices, as would be expected in attempting to master a heretofore unregulated market and regulate it almost from scratch in 360 days. For example, the basics of sell-side to buy-side vs. inter-dealer trading practices, CLOBs vs RFQs, and building liquidity that market participants take for granted have not been self-evident… though the good news is that the CFTC appear to be eager learners. By comparison, Reg NMS was a far simpler regulation, only promulgated by the SEC (i.e., not in coordination with the CFTC), and only applicable to long-established listed markets on exchanges, and yet even there it was many months before the qualified contingent trade exemption for options-tied orders came to pass. Of course a lot can happen in the two month comment periods after CFTC proposed regulations before final regulations are issued, and in overlapping areas (e.g., mixed swaps) the SEC is just getting started. Beyond that, in these truly global OTC derivatives markets coordination across regional regulatory regimes such as EMIR and ESMA’s MiFID II in the EU will also come in to play.
In biology, evolution has shown to march at its own inexorable pace in ways we are still attempting to understand. The notion of speeding evolution up or slowing it down, imposing an outcome, or any form of control has until very recently been farfetched (e.g., genetic engineering). Legislation and regulation in most forms impose the rule of law on established human practices. Such efforts in new, evolving, or poorly understood practices have always proven problematic regardless of the field. While much of the regulation coming out of Dodd-Frank related to CCPs and SEFs is clearly focused on the rule of law (e.g., concentration of ownership), there is also a good deal of ordaining OTC market structure, some seemingly mapped from listed markets (e.g., 15 seconds “pause” for other participation when crossing a trade on a SEF), others coming out of thin air (e.g., RFQ directed to a minimum of five participants). OTC derivatives markets are not listed markets, for many not yet for others not ever, notionally they are by far the largest in the world. All this regulation is certainly exciting, much of it overdue, but with just 360 days to write and 60 days to implement them, how well they will actually work in practice is a big question with just as much as stake as before the financial crisis that precipitated them. My guess is that this will be just the first regulatory pass with the best yet to come.