CFTC Commissioner, J. Christopher Giancarlo, recently released a whitepaper on swaps trading rules critiquing the CFTC’s implementation of Swap Execution Facility (SEF) rules and proposes instead an alternative framework that is more in line with the original intent and language of Dodd Frank Title VII. Jeff Steiner, Counsel, Gibson, Dunn & Crutcher offers his view of this report and the possible market wide response. Comments shared in DerivSource podcast.
Julia: Why are the SEF rules under fire? Why focus on swaps trading rules rather than CCP clearing rules?
Jeff: The concept of a SEF and a trading mandate were brand new to the swaps market. Yes, market participants utilized electronic platforms in the years leading up to Dodd Frank, but those markets really developed in an organic fashion and they weren’t subject to a trading mandate or restrictions on a particular trade execution method. Drafting the final SEF rules, the CFTC really didn’t know what the full impact of those rules would be on the market – it was almost really a chicken and egg situation.
As the whitepaper notes, the agency was aggressive in the manner in which SEFs can list swaps, including the Made Available for Trading (MAT) Mandate, and restrictive in the way SEFs can operate.
At this point, I think the agency and others are doing the right thing by looking at these regulations through a more refined lens to see what’s working and what’s not. Looking at things like liquidity for example, and asking if the rules are actually promoting SEF trading rather than driving market participants to find other alternatives, is a typical question the regulators should look at because the full impact of how these regulations would affect the market really couldn’t have been known at the time that they were written. So, it does seem like the SEF rules could really benefit from some modification.
With respect to the CCP rules and why those rules weren’t looked at first, I think you can contrast the SEF trading rules from the clearing rules. For the most part, mandatory clearing rules have worked pretty well for derivatives market participants. Part of that probably has to do with the fact that many market participants were already clearing swaps. For example, in the credit space people had been clearing credit default swaps for years, even before the CFTC mandated that they be cleared. So the transition was a lot easier, and I think a lot more intuitive for market participants to accept than this brand new SEF trading and mandatory trading regime that came out.
Julia: In the whitepaper, Commissioner Giancarlo mentions several adverse consequences of the current swap trading rules. What are the consequences highlighted that you believe to be of most concern, and why?
Jeff: I think liquidity issues are a really big concern and the whitepaper really focuses on those liquidity issues.
Fragmentation for example is harming liquidity and sending capital overseas as non-US persons are looking to trade outside the US on less restricted trading platforms.
We’re seeing separate liquidity pools develop for US persons and non-US persons, and the risk is that once this fragmentation develops, and it already has developed to some extent, we aren’t going to see those markets come back to the US.
Further, the whitepaper notes the issues surrounding the effects of regulatory action to curtail the use of name give-ups for its impact on market liquidity, which is a really interesting concept brought out in the whitepaper, that is: would sell-side dealers remove liquidity and increase pricing from the market as a result of restrictive requirements on give-ups?
Another big concern is the hindrance of technological innovation. The SEF trading rules presume that there are only two acceptable methods for executing what is known as ‘required transaction’, that is one that is subject to a trading mandate that must be executed on a swap execution facility or a designated contract market. Those types of transactions, which are required transactions, must be executed either on a central limit order book or with an RFQ process. As the whitepaper explains, there may be other execution methods that provide for greater transparency and better pricing that wouldn’t be permitted as an acceptable execution method. Possible execution methods can vary by market, by products, by a number of different factors and there may be such a method, which the market hasn’t thought of yet that may actually be more efficient.
As an example, some of the technological innovations that we’re seeing with virtual currencies and block chain technology, one would think that such technology or something similar could find its way into the execution of derivatives transactions. So, I guess to an extent incentivizing innovation that would allow for improved execution methods that may actually lead to more transparency, easier oversight for regulators. I definitely feel like anything that could restrict any of this type of innovation could certainly be a concern.
Julia: A new ‘pro-reform’ agenda is proposed in this whitepaper and this agenda has a fairly wide range of different proposals for better regulating the swaps trading market. Out of the various different proposals, which changes do you think are the most realistic and will have the greatest impact?
Jeff: Firstly, I think that the changes in the whitepaper are intended to operate as a package; I think Commissioner Giancarlo makes that point very clearly. That said, the change that will probably have the greatest impact would be permitting the more flexible execution methods; allowing other execution methods could help with market fragmentation issues, liquidity issues, and wouldn’t stifle innovation. Also, I think a number of other fixes that are referenced throughout the whitepaper could see some improvement if the use of more flexible execution methods were to be permitted.
I also think it’s realistic to expect to see some change on this front as other regulators have indicated more flexible execution methods, so harmonization with other rule sets could help to drive that change.
Another issue that the CFTC should consider and re-examine, and has been mentioned in the whitepaper, has to do with the made available for trade (or what’s known as the MAT process). Under the current rules, SEFs and Designated Contract Markets (DCMs) can make a swap available to trade and thereby the bind the market participants to execute those swaps on or pursuant to the rules of a SEF for DCM simply by self-certifying those swaps to the CFTC. This is a process that has served the futures market very well over the years, but the CFTC in this case doesn’t need to follow this process because the swaps market, as is highlighted throughout the whitepaper, is different than the futures market. Specifically, the swaps market is a global market with fungibility between contracts. I recognize that the industry certainly has resource constraints that have been highlighted over the years, but it strikes me that the CFTC would want greater oversight over this process that would burden market participants and how they can execute swaps.
Julia: Is there a recommendation in the proposed pro-reform agenda within the whitepaper that you find particularly surprising or even problematic?
Jeff: That’s a great question. I think one of the surprising recommendations in the agenda was the proposal to raise the standard of professionalism for market personnel. Included for discussion within the whitepaper is a requirement to take exams like the Series 3, Series 7 or other types of proficiency exams, and those requirements, depending on who they’re placed on and how they’re implemented could prove to be burdensome for certain market participants. We’ve seen in other market sectors, such as the introducing broker space after swaps were introduced, experience a grant number of burdens with respect to exam taking which meant that, after consideration, the agency lifted the exam requirements. The reason why this requirement is surprising is that, from an outside perspective, this requirement could be perceived to be a rollback, but clearly this particular provision (and some of the others) are not rollbacks but it would be a more restrictive requirement.
Overall, as with any of the rules, suggested changes should be implemented in a manner where they carefully consider the costs and consequences on the market participants.
Julia: Do you expect regulators will revisit the SEF rules as a result of the recommendations and opinions expressed in this whitepaper and, if so, what is the likely process to follow?
Jeff: I do think regulators are going to revisit the rules. I think CFTC Chairman Massad has already said in testimony and in some of his speeches that even looking at the SEF rules he acknowledged that some fine tuning of the rules may be necessary and may occur. So from that perspective I do think the leadership at the CFTC, Chairman Massad specifically and certainly some of the other commissioners, see it as an important agenda item in the upcoming year and maybe into the future to fix some of those issues.
We are seeing some of what the process entails in that the whitepaper is prompting discussions in the market place. The CFTC has also held public roundtables where SEFs, SEF users and others are joining the discussions over certain rules and to share what they are seeing this market.
I think we could see a rule proposal; a proposal that maybe amends some of those rules and that would go out for public comment and solicit feedback. However, we’ve also seen and certainly over the last five years and since Dodd Frank and the rules have been implemented, that there many ways to tweak the rules. Specifically, we’ve seen probably hundreds of no action letters, interpretations, other agency guidance come out that helps to provide the market with some certainty and ideas about how the agency views certain rules.
Listen to the podcast: http://development.derivsource.com/content/scrutiny-over-sef-rules-cftc-commissioner-giancarlos-whitepaper
