SEF Rules Need Clarification, Participants Say

Terry Flanagan

With mandatory trading of swaps on swap execution facilities just around the corner, the rules around SEFs require clarification, market participants say.

“The problem is there’s a lot of ambiguity in the rules, which has made it difficult for both SEF operators and market participants to know what trading protocols are permissible under the rules,” said Rick McVey, chairman and CEO of MarketAxess. “SEFs entail massive changes for interest rate swaps and CDS trading. We will get confirmation hearings for three new CFTC commissioners in February. If they do stick with the MAT [made available to trade] dates, which we believe they are planning to, and force everyone onto SEFs, they will be pushing a lot of volume into an uncertain SEF environment.”

Under the Dodd-Frank Act, once an SEF makes a MAT determination for a particular instrument, all transactions involving swaps that are subject to the trade execution requirement must be executed through a DCM (designated contract market) or a SEF.

“Since October, when the SEF rules on permitted transactions kicked in, most swap volume is still being done off-SEF,” said McVey. “Only 10% of CDS volumes were trading on SEFs in the fourth quarter.”

The Commodity Futures Trading Commission announced last week that MarketAxess SEF’s MAT determination for credit default swap (CDS) contracts is self-certified. The CDS contracts included in MarketAxess’ MAT determination were previously determined to be made available to trade as a result of an earlier MAT determination submitted by TW SEF LLC (Tradeweb) that was self-certified on January 27, 2014.

Under Commission regulations, these CDS contracts, whether listed or offered by MarketAxess or any other swap execution facility (SEF) or designated contract market (DCM), will be subject to the trade execution requirement, effective February 26, 2014.

The CFTC should clarify aspects of the “embargo rule” to ensure it does not harm the liquidity of the swaps market and create an unfair advantage of futures over swaps, said Marcus Schuler, head of regulatory affairs at Markit, in a comment letter.

The embargo rule prohibits SEFs and DCMs from disclosing swap execution data to their participants until the “transmittal” of such data to a swap data repository (SDR). Many SEFs and DCMs that connect directly to an SDR will have to halt the flashing of the transaction until the transaction data has been enriched and converted as required by the SDR, according to Schuler. Further, SEFs that use a third party to route data to an SDR may interpret the rule to mean that they need to delay flashing execution data until the third party has notified the SEF that the data has been sent to the SDR.

In both situations, the embargo rule could cause a delay for the flashing of the data to platform participants that, while small in absolute terms, would be long enough to prevent the practice of “work-ups” in most cases, thus reducing market liquidity.

“In contrast, these workflow challenges are not applicable to futures trading where DCMs are permitted to flash execution data as soon as a futures contract is executed because there is no equivalent embargo rule,” said Schuler. “The embargo rule therefore provides yet another incentive to trade futures instead of swaps.”

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