Futures Exchanges And SEFs Vie For Hegemony

Terry Flanagan

As U.S. regulators put the finishing touches to Dodd-Frank regulations, frictions between regulated futures markets and operators of swap execution facilities are bubbling up to the surface, suggesting that the transition of OTC swaps from a bilaterally traded and cleared model to an exchange-based model, envisioned by the regulations, could be a bumpy one.

The futures exchanges have longstanding machinery in place to execute and clear listed financial and commodity derivatives, and have begun applying that machinery to interest-rate swaps and credit derivatives.

Swap execution facility (SEF) operators, comprised largely of inter-dealer brokers that have traditionally acted as the marketplace for OTC derivatives, are concerned that the regulator, the Commodity Futures Trading Commission (CFTC), in its rulemaking, may be biased in favor of the futures industry, whose models don’t translate well to the OTC trading landscape.

“The biggest obstacle to getting rules right for swaps is regulators’ familiarity with cash markets, whether equities or commodities,” said Chris Giancarlo, executive vice-president of corporate development at brokerage GFI Group, at the Bloomberg Enterprise Technology Summit in New York earlier this month.

“Those markets have large numbers of retail participants trading a relatively small number of instruments, and high volumes,” said Giancarlo.

The swaps market, by contrast, has a smaller number of participants, almost all of them banks or large corporations, and a large universe of products that trade infrequently.

“Eighty per cent of referenced entities in CDS [credit default swaps] trade less than once a day,” said Giancarlo. “When you’re regulating a market with a few dozen participants, the exchange model doesn’t apply.”

The CFTC is preparing to promulgate a final rule on core principles for designated contract markets (DCMs) that could force off-exchange derivatives transactions from being traded on DCMs, and instead require them to be traded on SEFs.

Dodd-Frank requires that CFTC’s Core Principle 9 be amended such that boards of trade must provide mechanisms for executing transactions in a way that protects the price discovery process of trading in the centralized market.

The CFTC, in a proposed rule implementing this provision, has proposed that a minimum of 85 per cent of trading in any contract listed on a DCM must occur on the centralized market.

If a contract fails to meet this test, the DCM is required to delist the contract and transfer the open positions in the contract to a SEF.

The CFTC is hosting a roundtable on June 5 to seek input before drafting a final rule.

Exchanges have objected to the “85 per cent” rule, and have instead touted the efficiencies of providing integrated execution and clearing services.

“Customers appreciate the overall efficiencies that come with clearing multiple asset classes through the same clearing house, instead of dealing with the nuances of different venues,” said Laurent Paulhac, director of OTC products and services, at CME Group, the biggest futures exchange operator in the U.S..

Inter-dealer brokers, who are in the process of setting up SEFs, are concerned that exchanges may seek to bundle trade execution services with affiliated derivatives clearing organizations, or provide favorable pricing to customers who rely on one provider for trade execution and clearing.

“The tying of these two functions, familiar in futures markets, are antithetical to OTC markets and pose serious risks to their ability to function,” according to the Wholesale Market Brokers’ Association Americas (WMBAA) a body representing inter-dealer brokers.

The WMBAA noted that the Justice Department in 2008 had said that “vertical integration” in the form of bundles trading and execution services posed potential antitrust issues.

The three primary regulated functions—execution, clearing and reporting—should remain unencumbered by affiliation, collusion or cross-subsidization with commercial allies providing other regulated services, the WMBAA said.

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