Liquidity Fears Mount Over SEF Plans

Terry Flanagan

Swaps market participants are concerned that regulators are trying to shoehorn a vision of an exchange-traded model into a market that’s traded bilaterally or through wholesale brokers, with potentially calamitous results.

Many OTC derivatives contracts take place directly between sell-side dealers and their customers, such as institutional traders at hedge funds and other large buy-side entities. These dealers, in turn, use interdealer brokers to offset their positions and find the other sides of trades.

The applicability of central limit order books (CLOBs) to swaps trading is a hotly-debated topic among market participants as the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) wade through the convoluted Dodd-Frank rulemaking and implementation process.

In the SEC’s proposed rule, if a securities-based swap execution facility (SEF) operates a CLOB and a separate request for quote (RFQ) mechanism, then any trade would need to interact with existing interest on the central limit order book at the same or better price before interacting with interest on the RFQ platform.

Market participants are concerned that if a block trade were required to interact with other trading interest on a SEF, there might not be enough liquidity on the SEF to execute the entire block trade, leaving a portion of the block trade unexecuted.

“Regulators have familiarity with CLOBs in the futures markets, but that model doesn’t translate to swaps,” said Ron Levi, chief operating officer at interdealer-broker GFI Group. “Liquidity will dry up in swaps if CLOBs are mandated to the exclusion of other trading models.”

Market participants have urged exceptions for the handling of block trades, including the ability to negotiate and execute block trades without having to interact with resting orders.

An SEF is defined under FinReg as facilitating trading among multiple participants “through any means of interstate commerce”.

SEF operators want institutional investors to have the choice of executing block trades via a voice-based, RFQ or CLOB.

“The term ‘any form of interstate commerce’, which is enshrined in the legislation, means that SEFs can use telephone as well as electronic trading systems,” said Levi.

“Thus, the question arises: will we be allowed to use RFQ-based systems, which are extremely popular, or will we be limited to CLOB only?”

Market participants are also concerned about the CFTC’s proposed rules on when a particular swap has been “made available to trade”, or MAT for short.

The proposal provides that designated contract markets (DCMs) and SEFs will make the determination of when a swap has been made available to trade by considering seven enumerated factors, or any other factor that the DCM or SEF may view as relevant.

The incentive for a DCM or SEF to make MAT determinations are underscored by the history of central execution markets, which reflects that a significant, and perhaps insurmountable, first-mover advantage exists for the trading facility that first brings a given product to market.

Related articles

  1. CEDX is planning to expand its range of products in 2023, subject to regulatory approvals.

  2. The paper proposes a path forward for standard SLD documentation.

  3. Exchange group’s crypto suite has had consistent volume and open interest growth.

  4. The derivatives venue owned by FTX wanted to offer products that were not fully collateralized.

  5. The proposed standard applies to the processing of give-ups and allocations.