SEFs 2015 outlook: industry sees more flexible execution rules; harmonization

January 13, 2015

Regulatory efforts to simplify existing swap mandate rules in order to reduce fragmentation between the U.S. and Europe are likely to dominate the focus of participants in the swaps execution facility (SEF) market in 2015.

Indeed, harmonization and cross-border issues appear to be at the top of the agenda for the International Swaps and Derivatives Association (ISDA). In several speeches since becoming head of the industry group last year, Scott O’Malia, a former commissioner at the Commodity Futures Trading Commission (CFTC), has made it clear that for him regulators need to ensure that cross-border oversight is based on risk and not geographic location.

”Perhaps the biggest concern I have consistently heard over the past month or so is the importance of cross-border harmonization,” said O’Malia, shortly after becoming ISDA’s chief executive. ”In the medium and longer term, ISDA will remain focused on providing solutions to global regulators to resolve their differences and create an outcomes-based regulatory regime that relies on substituted compliance.”

Research published by ISDA last year showed that OTC derivatives markets have become fragmented along geographic lines since the start of the SEF regime in the U.S. in October 2013. The trend was most noticeable among euro interest rate swaps, with European dealers opting to trade with other European parties, avoiding U.S. dealers in Europe.

ISDA may have a strong ally in CFTC commissioner Christopher Giancarlo, who has also made market fragmentation in the SEFs market a key focus of his early pronouncements. Giancarlo, who was sworn in as a new commissioner last June, has a strong industry background and has highlighted several target areas for reform of existing SEF rules.

Execution methods, block trades and required vs. permitted transactions

Outlining specific changes he would propose to existing rules, Giancarlo in a speech highlighted several suggestions for improving harmonization with EU rules as well as promoting SEFs as an attractive venue for buyers and sellers.

  • Limits on execution methods: current SEF rules require a SEF to offer an order book for all transactions and limit the methods of execution on a SEF to an Order Book or Order Book plus Request for Quote System to three participants (RFQ System) for those transactions that meet the trade execution requirement. Giancarlo argued that the SEF definition lacks an all-to-all requirement as required by the Commission’s Order Book obligation. And, while the SEF rules acknowledge the phrase ”through any means of interstate commerce,” the CFTC reads it narrowly to allow for voice and other ”means” of execution or communication, but still prohibits SEF execution methods beyond the Order Book and RFQ System.
  • Block trades: the CFTC currently requires block trades – large trades above a certain size — to be executed away from SEF platforms. Giancarlo has argued that the CFTC should rethink the ”occurs away” requirement for swaps trading. ”The requirement is a holdover from the futures model. It has no relevance in the swaps markets, where blocks and non-blocks trade through a variety of execution methods depending on liquidity and other characteristics,” he said.
  • Required vs. permitted transactions: another area of criticism is the so-called artificial distinction between permitted and required trades. By creating such an artificial distinction between swaps on SEFs and their corresponding execution methods, the CFTC is forcing swaps to trade through limited execution methods before the appropriate liquidity is available to support these execution methods, argued Giancarlo.

Giancarlo is expected to publish a white paper on proposed reforms early this year.

Rule tweaking under “pragmatic” CFTC head Massad

Yet with Giancarlo as the sole Republican on the CFTC board, just how effective will he be in pushing for changes to existing swap rules? Some industry experts believe the key will be with the chairman of the CFTC, Timothy Massad, who many view as a more pragmatic and less ideological policymaker.

”Chair Massad understands that swaps are fungible across borders, and he said he would like to make fixes. I do believe he will make some fixes that will be helpful to the market,” said a former government official and now an industry expert.

Areas such as block trades and execution methods are seen as areas where ”certain fixes” could be made without being seen as rewriting the law in total. Under former chairman Gary Gensler, observers say the CFTC was under enormous pressure to ”get the job done” on writing SEF rules, and perhaps did not take as much time as needed to understand the market effects that might emerge from certain decisions.

”Massad has a different role now than Gensler,” added another legal expert. ”I think Massad is in the implementation world and has to deal with consequences of what was written. This is a different scenario and opens up areas for change.”

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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