Emergence of SEFs Raises Questions

Terry Flanagan

Swap execution facilities are coming, and more than three years after Dodd-Frank was signed into law, there is still massive uncertainty as to how the business will operate.

Just last week, London-based inter-dealer broker Tullet Prebon filed a SEF application with the Commodity Future Trading Commission, just weeks ahead of an October deadline for U.S. market participants to trade swaps through SEFs. Bloomberg has already been approved as a SEF; other applicants include GFI, IntercontinentalExchange, MarketAxess, Tradeweb, Integral, Javelin Capital Markets, TerraExchange, and State Street.

The backdrop for the emergence of SEFs is the regulatory push in the U.S. and Europe, spawned by the global financial crisis of 2008-2009, to move derivatives trading from off-exchange, privately negotiated transactions, onto lit and transparent exchanges with central clearing.

But the new corner of Wall Street represents uncharted territory, and even swaps-market participants and prospective SEF operators aren’t sure what to expect.

Broadly, there is uncertainty about a new market essentially created by regulation, as there’s little or no modern precedent for such a development that could be consulted as a blueprint, according to an executive at one SEF applicant. And there is a litany of more granular questions and concerns.

Compliance is one concern. Not only is the ink barely dry on the new regulations, but more importantly, final implementation has yet to occur, and it’s an open question as to how regulators will interpret the rules, i.e. whether they will err on the side of leniency or strictness.

Another issue is connectivity. As the source at the SEF applicant said, how can market participants know which SEFs have the best connectivity to enable the fastest and most reliable trading?

Liquidity will be a massive consideration, as it is with all financial markets. Specific to the derivatives markets, it won’t be ‘one size fits all’, so significant questions surround which derivatives will have comparatively deep liquidity on electronic platforms, and which will be thinly traded.

There are also questions regarding the competitive landscape, or which SEFs will survive and thrive over time and which may never get traction. Lastly, there is  ongoing uncertainty as to the new role of the trader, which has moved from the top of the pecking order, to perhaps behind compliance, legal, and operations staff in the corporate hierarchy.

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