‘Futurizing’ the OTC Market

Terry Flanagan

Dodd-Frank represents a move toward ‘futurizing’ the OTC swaps by moving them to an exchange model, which is a big change from the bilateral world, in which banks handled most OTC transactions on behalf of end users, i.e., corporations and asset managers.

“The rule making has been pretty extensive,” said Jacob Preiserowicz, special counsel at Washington, D.C. law firm Schulte Roth & Zabel. “The CFTC is regulating a lot more of the industry than they have done in the past. That does require the industry to modify a lot of what they’ve done, whereas in the past there may have been more flexibility in what they can and can’t trade, and who was overseeing them. That has changed a lot over the last three years. Asset managers who are focused at all on the commodity space are almost certainly going to have to register with the CFTC.”

Jacob Preiserowicz, Schulte Roth & Zabel

Jacob Preiserowicz, Schulte Roth & Zabel

One of the complicating factors is in determining ‘U.S. person’ status for Dodd-Frank purposes. “Especially if you’re based in Canada, is your fund a ‘U.S. person’ and you’re required to trade in SEFs, or can you just stay off SEFs altogether?” said Preiserowicz. “It gets more complicated if you have different products, some which could be domiciled in different funds, and some could be U.S. persons and some will not be.”

Preiserowicz, a former special counsel in the Commodity Futures Trading Commission’s Division of Swap Dealer and Intermediary Oversight, advises hedge and private equity fund managers with respect to futures and swaps trading, as well as CFTC and exchange rules concerning OTC and listed derivatives.

Today, interest rate swaps and credit default swaps must trade on SEFs and then clear, and commodities aren’t far behind. “Commodity swaps aren’t there yet, but we could get there eventually,” said Preiserowicz. “I know the CFTC expects it by the end of the year. The CFTC doesn’t always keep to their deadlines, but they put it on the calendar. There’s a new chairman now, and this is his number one priority right now, or at least he said as much.”

Once firms register with the CFTC, they will face a host of ongoing reporting requirements on a quarterly basis, as well as the occasional audit from the CFTC. “In the past you never had to deal with that,” Preiserowicz said. “Most of the industry was exempt from CFTC registration prior to Dodd-Frank.”

The initial reaction to SEFs was largely one of avoidance, but this has given way to a realization that the trading venues are here to stay.

“The on-boarding process was a bit complicated at first, with people trying to figure out who needs to on-board, i.e., should they be a direct member or go through some other members, but over the course of the past year, it seems to have become a little more routine,” said Preiserowicz. ‘The on-boarding process has become much more seamless.”

As to whether funds are getting a return on their investment from registering with and trading on SEFs, it depends on whether the fund trades a significant amount of interest rate swaps and CDS. “If that’s a big part of what you do, the cost isn’t superlative,” Preiserowicz said. “If it’s a small part, if you’re only going to enter into an occasional interest rate swap, the whole on-boarding process is pretty burdensome, just to be able to do that occasional trade. That’s definitely been an issue for some of the industry.”

Preiserowicz will discuss these points on the Commodity Trading & Investing panel at Markets Media’s Canadian Trading and Investing Summit, which will take place April 1 in Toronto.

Overall, funds have yet to see tangible benefits from SEFs to offset the associated costs, according to Preiserowicz.

“For the ones who are using these instruments pretty regularly, I don’t think that they’ve seen the benefits from it,” he said. “Once it’s been integrated into trading, it’s been fine. There haven’t been too many issues. But it’s not necessarily more beneficial. I don’t think they’ve found that they’re getting better pricing like they have in the past.”

CFTC Commissioner Chris Giancarlo on Jan. 29 published a whitepaper criticizing how the CFTC has implemented the execution of swaps trading on regulated platforms.

Preiserowicz suggested that the CFTC should seek more industry input at the rule proposal stage. “Right now, the process we have a proposed rule and then a comment period where you get comments from the entire industry,” he said. “For example, with the position limits rule, they keep on reopening the comment period again and again. They would be better served by taking the industry’s view into account prior to even having the proposed rule in place.”

Featured image by Myst/Dollar Photo Club

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