State Street’s Tomas Zikas talks to DerivSource about the implications of the recently announced Swap Execution Facility (SEF) rules and how the market can prepare for implementation in the next several months.
Q. The CFTC announced SEF rules May 16th that the market has been digesting since. Can you offer a quick overview of what these newly announced rules mean for SEFs and the industry in general?
A. Despite the long delay, there is less ambiguity surrounding the rules on execution for derivatives markets now that the Commodity Futures Trading Commission (CFTC) has announced some rules for the governance of SEFs. Determinations have been made about the minimum number of recipients that a request for quote (RFQ) must be sent to for execution via SEFs. Originally it was proposed that an RFQ must be sent to at least 5 recipients for every transaction but this has been reduced to two recipients in the first year and three recipients thereafter. Adjustments to the minimum quote requirement have been made to take into consideration the overall market landscape, assessing the needs and requests of the traditional liquidity providers, the sell-side dealers as well and meeting the CFTC’s requirements to drive and force competition and spread accessibility to other non-standardized liquidity providers.
Additionally, the CFTC has devised block rules to be effective from day one at a level that represents 50% of the average transaction size initially available increasing to 67% after the first year. Certain market places, which historically have used RFQ-driven platforms, may be required to incorporate a central limit order book. Participants will have to undertake due diligence when selecting a SEF to ensure the SEF actually meets the requirements.
Governance provisions need to be considered: ownership structures, board compositions and committee set-up procedures on SEFs. The CFTC also finalized a rule on how and when the made available for trade determinations can be made.
The points of principle interest for the market place will trigger off the Federal Register publication date of the final SEF rules. The effective date of those rules will follow 60 days after that publication date and will be the first window for the provisional registration of SEFs with the CFTC.
With provisionally registered SEFs and a formal made available for trade determination by the CFTC could result in certain trading instruments being required to be traded on a SEF as early as the December time line. Even though December feels like it is a fair way off it is precious little time for everyone to react.
Q. How do you expect electronic trading to evolve from the initial mandate to its mature-end state?
A. SEF adoption will, we believe, evolve in four phases. The first phase will be characterized by fragmentation. Inevitably participants in the derivatives market will have their own opinions as to which SEF will bring them the greatest value, best access to liquidity and the best customers. There is fragmentation by SEF and fragmentation by execution style in that it is a RFQ market, central limit order book market and an indication of interest market.
There will be a fragmentation of participant type; investment managers versus liability driven investors versus swap dealers versus major swap participants who are all seeking different types of execution styles and different liquidity pools. You will also see fragmentation by instrument type; credit default swaps versus interest rate swaps versus FX derivatives versus commodities. Finally, you will have people with the best will in the world who want to trade but will not be ready to trade and liquidity may not be available for a period of time.
In the transition phase certain early adopters, probably those characterized by traditional counterparties, will have made a determination to evolve their business model in line with the regulatory pressures driving liquidity on the SEFs or Designated Contract Market (DCMs) that they support. This is evident with one current DCM, Eris Exchange, where the investor supporter Morgan Stanley is clearly driving participation on that venue.
The third phase will be an inflection point, and liquidity on the SEFs with anchored tenants will start to grow and multiply as more counterparties identify and recognize interesting liquidity growth on a particular SEF. The mature phase follows and we believe the market will blow through its current volume statistics and grow albeit perhaps with smaller trade sizes. There will be more volume and more trade velocity than ever existed before in traditional markets.
At SwapEx, which is State Street’s SEF offering, we have created a SEF to contend with fragmentation issues. SwapEx has a tool kit of different execution of styles catering to the diverse needs of traders and hopefully better serving the derivatives market.
Q. Given the inclusion of voice execution what role might voice play in the new e- trading revolution?
A. A strong lobby by the traditional voice brokerage community has preserved voice as an allowable method of execution as it falls under the definition of any means of interstate commerce. However, as a participant when considering venues you have to take into consideration how compliant the SEF or the DCM is and whether you will be sufficiently protected.
At State Street, we have looked at the capacity of our own SEF and whether there is a need, or a role for voice. We believe that voice alone without the combination of an electronic trading platform for matching would struggle to stand alone as a compliant platform. SEFs have obligations for audit trails. They have intraday real-time compliance monitoring to look for illicit trading practices and technology heavy requirements that, in the absence of digitalized technology, would put stress on voice. However, voice orders received then transmitted into a SEF owned by the voice entity itself is something that could work.
Q. What practical challenges do participants in the swap market face in the coming 9 months in relation to the adoption of SEFs?
A. I believe we could have a situation where trading determination is made available as early as December of this year. So, if you want to participate on a SEF you need to make sure you are legally subscribed to that SEF, technologically connected to and authorized to participate on that SEF. You need to have a clear relationship with a Futures Commission Merchant (FCM) to represent your business in a clearinghouse. There are many external dependencies, internal reviews and preparation work that will be required to be ready to trade on a SEF.
Also, there is going to be tremendous legal and IT logjam in terms of adoption and preparation. At SwapEx we have prepared our own participant agreements and rulebooks required by the CFTC for each SEF. Voluminous legal documents exist and are largely modeled after the DCM requirements, and I would encourage every market participant to prepare for and anticipate for this document logjam and a practical squeeze on time in order for you to be able to get connected to SEFs.
Q. Given the practical challenges, which you have outlined would you say that people have very little time to prepare for implementation for execution by SEF?
A. Participants who leave the preparations to the end of the summer or the fall will find themselves in a very difficult spot when it comes down to getting the internal and external resources to get things going. At SwapEx we are working with counterparties to get them through the process, through the meat grinder so they can trade in derivatives and run their business. People should jump into the process sooner rather than later.
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