When the Commodity Futures Trading Commission approved its final rules on swap execution facilities (SEFs), it included a footnote which was little noticed at the time but since has been making waves in the OTC trading community

Footnote 88 states that “a facility would be required to register as a SEF if it operates in a manner that meets the SEF definition even though it only executes or trades swaps that are not subject to the trade execution mandate.” This means that the SEF rules would apply to any transaction the SEF offered, whether or not that transaction is mandated to trade on a SEF.

Footnote 88 “represents a troubling “extra” to the CFTC’s final SEF rules, ensnaring many existing electronic platforms in SEF regulations most market participants did not expect to apply there,” said David Weiss, senior analyst in Institutional Securities & Investments at Aite Group. “The SEC, to say nothing of foreign regulators, may very well take a different stance on permitted transaction-only electronic trading platforms. Should the CFTC not revisit or further clarify 88 (i.e., in greater depth than a footnote), the cleaving of the FX derivatives market between the United States and other countries will be the harbinger of similar splits to come.”

Still, said Weiss, “for a regulation that had so many lobbyists concerned about the continued flourishing of the OTC derivatives market, Dodd-Frank’s execution mandate has certainly resulted in a great blossoming of SEFs. But all are not roses and SEF consolidation is a must before liquidity thrives and more SEFs may blossom again.”

Confusion over Footnote 88 and the cross-border applicability of the SEF rules person have resulted in liquidity concerns from market participants, which prompted the International Swaps and Derivatives Association (Isda) to conduct a SEF Market Fragmentation Survey to obtain a clear picture of potential market disruption or fragmentation resulting from SEF rule implementation.

The survey’s findings reveal that liquidity has been fragmented across platform and cross-border lines resulting in separate liquidity pools and prices for similar transactions.

Several participants revealed that total derivative trading volume measured as a percentage of notional amount decreased from October 2 (the SEF registration deadline) particularly in credit and foreign exchange derivatives. Eighty-four percent of survey participants believe non-US persons are choosing not to trade on SEF platforms as a result of CFTC rules coming into effect in all swap categories: interest rate, credit, foreign exchange, equity and commodity derivatives, while 68% of participants believe trading activity with US persons is being reduced or has ceased as a result of the SEF rules.

Over half of the responses indicate the presence of market fragmentation, such as the formation of separate liquidity pools for US persons, while 61% of participants believe trading has been redirected from electronic to voice trading as a result of the SEF rules coming into force.