SEFalicious – Market Evolution Meets Regulatory Revolution

David B. Weiss, an independent consultant and research analyst, discusses the current state of SEFs and what the future holds for these trade execution facilities

The US Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission’s (SEC) proposed regulations implementing 848 pages of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) legislation in the US and similar regulations coming from Markets in Financial Instruments Directive (MiFID) II in the European Union (EU) will, among many other things, expand several existing regulatory regimes to Over-The-Counter (OTC) derivatives as well as try to standardize OTC derivatives products and mandate their clearing on existing and to-be-formed central counterparty clearinghouses (CCPs).  Most notably in regard to the clearing initiative, in the US this also includes trading of any cleared OTC product on swap execution facilities (SEFs) wherever available and possible.  While the clearing business is well formed and the source of potential OTC CCPs relatively obvious, less clear is where the SEFs will come from and in what form.

As per the Dodd-Frank Act, the CFTC and SEC proposals have pretty much defined swaps and security-based swaps respectively as covering almost all currently unregulated OTC derivatives.  The US Secretary of the Treasury has exempted the majority of foreign exchange (FX) swaps and forwards (subject to final exemption determination in July 2011), though FXO FX options (FXO), currency swaps, and non-deliverable forwards (NDFs) remain covered.  CFTC and SEC proposed rules mandate clearing standardized OTC derivative products on CCPs for risk mitigation, transparency to regulators, and counter-arty neutral clearing.  CFTC and SEC proposed rules then mandate any now-cleared OTC product to trade on a SEF once one or more SEFs become available, viable, and the trade is possible… the precise criteria and triggers for such a mandate are as yet unclear (e.g., what product is “available to trade”).

SEF Revolution

The Dodd-Frank Act’s scope is vast and if left intact guaranteed to revolutionize OTC derivatives, particularly those aspects of the Dodd-Frank Act focused on SEFs.  The Dodd-Frank Act defines a SEF as a “trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants.”  The CFTC will regulate SEFs, with their current Exempt Board of Trade (EBOTs) all transitioning to SEFs, and the SEC will regulate Security-Based SEFs (SB-SEFs).  In very general terms, SEFs and SB-SEFs are proposed to be electronic markets bearing many similarities to listed exchanges in terms of equal and open membership rules and access and multi-to-multi member participation, either via 

1) CLOB Central Limit Order Book (CLOB) as on an exchange or 

2) Request For Quotes (RFQs) as in current single-dealer systems, except that RFQs must be capable of being made to as many liquidity providers as on the market.

Swaps that are not required/yet to be cleared on a CCP are of course exempt from the requirement to trade on a SEF, as are block trades and those swaps where one-side is an end-user (e.g., not a financial entity) engaged in hedging/mitigating commercial risk.  SEFs may have separate provisions for block trading, and end-users may still choose to trade on SEFs.  SEFs need to provide confirms, downstream connectivity to CCPs, and trade reporting.

While the CFTC and SEC proposals have much in common, there are some notable differences.  The CFTC requires that an RFQ be sent to a minimum of 5 liquidity providers, whereas the SEC allows for RFQs to be made to as few or many as a member desires with an RFQ to just 1 liquidity provider allowed.  The CFTC requires that trades entered by brokers for buyer and seller customers (i.e., crosses) or against a customer sit 15 seconds before matching and executing to allow for better pricing from other members.  The SEC requires all quotes responding to an RFQ, including for a block trade, to publicly display as a “composite indicative quote”.  CFTC and SEC criteria for block trades also differ, though both are currently unclear.

These are just some of the highlights of the proposed rules that the CFTC and SEC have in common and where they differ.  Heretofore in the listed markets the bifurcated regulatory model hasn’t posed much of a burden.  However in the OTC markets, while many products would be strictly regulated by the CFTC on a SEF (e.g. commodity derivatives) or SEC on a SB-SEF, Credit Default Swaps (CDS) and equity swaps would be subject to both.  For CDS and equity dividend/variance swaps, those based on indices (e.g., CDX, SPX) would be subject to the CFTC’s SEF rules and those based on single-names would be subject to the SEC’s SB-SEF rules… on the same SEF, with parallel architecture for each type.  Currently no passport regime has been put in place so it’s entirely possible that CDS and equity swap SEFs would need to register with both the CFTC and SEC.  For those products caught in this bifurcation web, the current differences between the CFTC’s and SEC’s proposed rules would be quite problematic.

Electronic Trading Evolution

Compared to cash markets, OTC derivatives have been evolving relatively slowly, with a great deal of voice trading remaining.  Several Electronic Trading Platforms (ETPs) for select OTC derivatives products are currently available around the world, some globally, with varying liquidity.  Today’s evolving ETPs could become tomorrow’s SEFs for the products they currently support as well as related products.  Some have been around for 10 years, others just 1 year, and some freshly formed expressly to be SEFs.  Regardless of longevity and current success, it is uncertain whether many of these ETPs will choose to attempt and ultimately succeed in transforming themselves into SEFs, particularly in regards to achieving critical liquidity mass.  Certainly today ETPs with both current liquidity and the commitment of trading parties to achieving critical liquidity mass upon transformation to SEFs have a good chance.

Most OTC derivatives trading is bilateral between sell-side dealers and buy-side customers.  There is also inter-dealer trading between sell-side firms.  Initially traded via voice, some of these markets have evolved to hybrid and the most liquid have become electronic in the plurality or majority.  Except for the FX market, much of the non-voice trading is via bilateral single dealer ETPs put out by sell-side firms and far fewer multilateral ETPs… lots of individual ETPs for the buy-side to work with and aggregate on their own.  Much inter-dealer trading is facilitated by inter-dealer brokers (IDBs), and the larger ones too have created their own ETPs as an extension of their voice trading just for the sell-side.  Several FX multilateral or multi-party ETPs exist.  As well the electronic post-trade service MarkitWire (formerly SwapsWire) has for 8 years supported the electronification of the existing International Swaps and Derivatives Association (ISDA) documentation and contracts already in place between counter-parties for ~300 sell-side, buy-side and IDB participants.  

Almost all the multi-lateral ETPs that do currently exist are either buy-side to sell-side or inter-dealer, with no generic access for all trading participants.  This is in sharp contrast to how all the listed products cleared by CCPs are traded (e.g., on exchange).  What ETPs and listed markets do have in common is FIX Financial Information eXchange (FIX) messaging, which many ETPs use for their open application programming interfaces (APIs), often in addition to their own proprietary APIs.  In listed products FIX has facilitated liquidity formation and electronic trading activity since its inception in 1992, really taking off in 1998 with RegATS.  Unfortunately FIX has not had the same evolutionary impact on derivatives generally and OTC derivatives especially.

SEFalicious

Many of today’s ETPs are candidates for tomorrow’s SEFs by virtue of having technology in place and, to varying degrees, liquidity flowing on their systems.  There is great variation in global reach, asset classes, trading participants, products available, liquidity commitment, self-imposed technology limitations, and market structure.  Some of these ETPs have been formed expressly for the purpose of registering as SEFs, others will seek to transform, and a few will register as Designated Contract Markets (DCMs).

There’s still a great deal of pre-trade price discovery conducted via Instant Messaging (IM).  The major IDBs and banks have their own sophisticated ETPs, which generically fall under the Inter-Dealer Platforms and Single-Dealer Platforms entries respectively.  Both face significant and unique challenges to their business models from the current multi-to-multi member participation and open access requirements in proposed SEF rules.

For those firms interested in creating a SEF but not fortunate enough to already have an ETP as above, there are also number of Independent Software Vendors (ISV) with products particularly well-suited for the technical foundation of a SEF (e.g. Baymarkets, Cinnober, GFI Trayport) and related ISV and service providers for valuation of the products trading on SEFs (e.g. Interactive Data, Markit, Numerix, Reval, SuperDerivatives).  Established or new players in OTC derivatives could leverage their offerings for out-of-the-box SEF solutions or major functionality via licensing, partnership, or acquisition.

ETP ==> SEF

Given that technical and capital barriers for creating a SEF are low compared to those for a CCP, once CCPs are in place for OTC derivatives much of the heavy technical lifting will have been done to facilitate SEF transition and/or creation.  Likewise currently segregated ETPs will more easily be able to form more open SEFs accessible by all trading participants.

Lest one think this is just a US game, in the EU many the initiatives being contemplated for/debated in MiFID II have a lot in common with those in the Dodd-Frank Act, including the mandate to clear OTC derivatives on CCPs.  There the SEF counterpart is called an Organized Trading Facility (OTF), situated below current Multi-Lateral Trading Facilities (MTFs) and RMs (Regulated Markets).  How similar OTFs will be to SEFs will likely become clear only once the deliberating Committee of European Securities Regulators (CESR) becomes the regulating European Securities Markets Authority (ESMA). As well, individual Asian regulatory bodies are working on their own reformatory regulations.

While the CFTC and SEC rules (and even the Treasury’s FX determination) are just “proposed”, and MiFID II is not as far along, CCPs are getting ready… the SEF trend is not a matter of “if” but “when”.  The SEF revolution may be just the thing to accelerate ETP evolution in OTC derivatives markets like we’ve seen ~10 years ago in cash markets.  The big question is whether all those ETPs can survive as SEFs in a fragmented OTC derivatives market or consolidation will thin their ranks.

This column is derived from an extensive research note on SEFs written by David B Weiss. Please contact Mr. Weiss for more information on his research