Claiming that Dodd Frank’s Title VII rules post-financial crisis legislation has not moved swaps trading onto SEFs as hoped and led instead to increased market fragmentation and costs, CFTC head Christopher Giancarlo looks set to loosen derivatives rules. Lynn Strongin Dodds looks at a recently published White Paper and the potential impact of reforms.
Just as he promised when serving as acting Chairman of the Commodities Futures Trading Commission (CFTC), Christopher Giancarlo, who officially took over the helm in March, is moving ahead with derivatives reform. The recently published White Paper, Swaps Regulation Version 2.0, is certainly sweeping in its coverage, but time will tell if it can deliver the lighter touch pledged three years ago.
At first glance, Giancarlo’s White Paper, co-authored with CFTC chief economist Bruce Tuckman, seems to be heading in this direction. They do not mince their words and are critical of the Title VII or OTC rules under Dodd Frank, arguing that they have failed to achieve their goals of moving swaps trading onto swap execution facilities (SEFs). Instead they claim the legislation has disincentivised price discovery and liquidity formation by limiting the execution methods as well as the number of products due to an overly narrow “made available to trade” (MAT) definition.
Other adverse consequences mooted in the paper include market fragmentation, additional costs under the order book requirement and leakage of information emanating from the send a request-for-quote (RFQ) obligation to three or more unaffiliated parties. They also highlighted the widening cross border gap between US and European dealers’ trading line. According to an ISDA survey cited in the White Paper, the average cross-border volume of euro interest rate swaps (IRS) transactions between the two regions as a percentage of the total market for the product has fallen from 25% to 10% since the SEF rules came into effect
Giancarlo and Tuckman hope to tackle these issues by allowing SEFs to trade swaps ‘through any means of interstate commerce instead of through artificial, prescriptive execution methods.’ In other words, they suggest eliminating the existing MAT process and broadening the number of swaps subject to the trade execution requirement to include all those under the clearing mandate. The hope is that loosening the reins will generate different order types and methods of execution which in turn will increase electronic trading.
Market observers say Title VII limits trading options and hampers innovation
“One of the problems with the regulation implementation of Title VII is that it tried to shoehorn swaps captured within the MAT determinations into a specific way to trade and it didn’t really catch on,” says Colby Jenkins, research analyst at TABB Group. “The result is that if you trade on a SEF you typically use an RFQ. However, if they do away with MAT and the Central Limit Order Book (CLOB) or RFQ SEF execution mandate as proposed, the view is that this could lead to greater flexibility and innovation as well as improved execution.”
These views are also echoed in a new report by Greenwich Associates, SEF Rule Changes to Accelerate Innovation in Swaps Trading. According to Kevin McPartland, co-author, managing director and head of Research for Market Structure and Technology at the consultancy, over time, the move towards “any means of interstate commerce should both decrease the compliance burden for SEFs and increase innovation such as improved requests for stream, auctions and dark pools.”
He adds, “If dealers and their clients don’t feel constrained by trading protocol regulations, there will be less incentive to actively trade off-SEF, given the now well-appreciated efficiency gains they bring—fewer errors, quicker trade confirmations, real-time credit checks, and an easy path to the clearinghouse.”
“If dealers and their clients don’t feel constrained by trading protocol regulations, there will be less incentive to actively trade off-SEF, given the now well-appreciated efficiency gains they bring—fewer errors, quicker trade confirmations, real-time credit checks, and an easy path to the clearinghouse,” says Kevin McPartland, Greenwich Associates.
Electronic trading could also fulfil its potential. Volumes may have jumped from 45% to 65% over the past four years for vanilla fixed float interest rate swaps, but this is nowhere near where regulators had anticipated. Market participants believe that the CFTC would like activity to emulate the world of central clearing, which has a roughly 98% hit rate for these products.
“While we saw a big jump in buy-side SEF trading following the implementation of the mandate in 2013, e-trading levels have remained relatively flat ever since,” says McPartland. “We think requiring all mandatorily cleared products to trade on SEF will increase usage considerably as well as the total volume executed on SEF.” He estimates that once fully implemented, the reforms could increase the average daily notional volume requiring trading on SEF by as much as 50% while actual volumes could jump by 20%, given the voluntary SEF trading that currently occurs.
Technology innovation also drives change as participants seek greater transparency and TCA
Dan Marcus, CEO of Trad-X, is not sure that legislative reform is the sole catalyst for change and that electronic trading of OTC derivatives could definitely increase. “It is not only a regulatory incentive that is changing the way derivatives are traded,” he adds. “The industry is evolving and counterparties are expecting greater levels of transparency in an electronic or hybrid trading environment to enable confident transaction cost analysis. It is up to platforms like Trad-X to facilitate the provision of high-quality liquidity encapsulating firm, tradeable two-way pricing in real-time to support this transition.”
Although the future of SEFs has dominated the headlines, the White Paper also devotes several chapters to the back and middle office functions of the derivatives universe. For example, on trade reporting, the authors advise the CFTC to tap into the deep pools of research and analysis from industry and academia to enhance the public reporting requirements and to paint a better-rounded picture of activity. In addition, they are planning to delve further into the sphere of emerging digital technologies, such as cloud computing, automated big data analysis and distributed ledger technology to make trade data reporting more accurate, reliable and automated.
They also target central counterparties (CCPs). Despite their success, the CFTC remains apprehensive over the liquidity of margin and prefunded resources as well as the possibility of correlated defaults and contagion effects. The White Paper is not only calling for the relative sizes of resources to be examined within the default waterfalls but is also encouraging more research into these systemic institutions.
Uncleared margin also comes in for close inspection because of the seemingly overly rigid nature of the rules. Giancarlo and Tuckman contend the interpretation has led to the unintended consequence of pushing the industry to converge on a single, global margin model for swaps. They believe that this is a source of systemic risk and recommend allowing banks more leeway to use their own internal models.
Final recommendations not expected for at least a year
It is still early days though and not surprisingly, no one is willing to predict what the final version of the recommendations will look like. The one guarantee is that it will take time for the wheels of regulation to turn and in this case, the White Paper will be presented before the full set of five commissioners – it has taken years to fill all the vacancies – in September before going out to consultation for 75 days. The timeframe is then unclear.
“I do not expect to see any new rules finalised until around this time next year, says Scott Fitzpatrick, CEO of Tradition SEF. “However, this is the CFTC’s opportunity to get it right and they have engaged extensively with the industry in a positive way.”
Jenkins adds, “there is a lot of speculation and people are reluctant to comment on the impact because there is still a great deal of uncertainty. The White Paper that was recently released is in many ways a reiteration of Giancarlo’s earlier comments when he was acting chairman in terms of addressing the shortcomings and successes of Title VII implementation. I think his point of rethinking certain execution mandates makes sense.”