After three years of intensive dialogue between regulators and the derivatives industry, swap execution facilities, one of the foundations—along with swap data repositories (SDRs) and designated clearing organizations (DCOs)-of the OTC reforms embedded within the Dodd-Frank Act, will officially open for business on October 2.

To date, there are close to two dozen SEFs that have already registered and been approved by the Commodity Futures Trading Commission, with more to come.

The advent of SEFs represents a milestone in the history of interest rate swaps, credit default swaps, and other OTC derivatives. For the first time, OTC contracts that meet basic criteria of liquidity as set forth by the Commodity Futures Trading Commission and the Securities and Exchange Commission must be executed on either a SEF or a designated contract market (i.e., an exchange), reported to an SDR, and cleared via a DCO.

“The OTC trading community has undergone more change over the past six months as the Dodd-Frank rules have become finalized than it has in 20 years,” said Rishi Nangalia, CEO of Redi Global Technologies, a former electronic trading subsidiary of Goldman Sachs that was spun off earlier this year. “As SEFs come online, there will be a greater move of OTC trading from voice, fax, and IM to fully electronic.”

The newly regulated marketplaces will operate technology platforms that offer different derivatives trading methodologies, allowing market participants to execute strategies in different ways to meet their unique liquidity needs, whether that’s through a disclosed request-for-quote, a central limit order book, or a hybrid voice/electronic model.

Emerging Infrastructure
Interdealer broker Icap has registered as a multi-asset SEF and intends to offer trading in many of the OTC swaps previously brokered by its various affiliates. The SEF will offer trading in swaps designated as both Permitted and Required Transactions, including rates, credit, FX, commodities and equity derivatives.

Clearing messages will be sent via Markit. “We are looking toward the day when pre-trade credit hubs like Traiana and MarkIt are in place for mandatory cleared products,” said Icap managing director Chris Ferreri. “We will be using DTCC for the SDR.”

To get an idea of the change in market structure, Icap managing director Ferreri suggests picturing three concentric circles, similar to a Target store logo. At the center are the Interdealer Brokers, in the middle ring are the sell side dealers, and in the outer ring is the buy side. “Now picture 11 or 12 Target logos with the SEFs in the middle and the lines blurred by impartial access requirements, each interacting with DCOs and SDRs,” he said. “I think you can see that this represents a sea change in the markets and one that is happening in a relatively short time.”

Icap’s voice and hybrid clients will be able to access the Icap SEF via their existing Icap broking relationships, several of which have registered with the CFTC to become introducing brokers in order to place and execute orders on the SEF.

Operators of SEFs and DCMs are working with their clients to address the implications of this compliance, in particular the need to enforce trading limits on a pre-trade basis. “For IRS trading on the iSwap platform, we provide clients with the ability to set limits for a market participant against all resting orders on a pre-trade basis,” Ferreri said.

Although the CFTC finalized its rules for SEFs on May 16, 2013, there are still issues that need to be addressed, especially the Commission’s determination—contained in footnote 88 in the final SEF core principles rule—that a facility will be required to register as a SEF if it operates in a manner that meets the SEF definition, even though it only executes or trades swaps that are not subject to the trade execution mandate.

“With footnote 88, the CFTC states that it doesn’t use the clearing mandate to determine SEF trading status but rather the mode of execution. Any multiple to multiple platform that intermediates CFTC-regulated swaps must register as a SEF. This broadens the scope of products that are added to the IDB universe of products that will be executed on SEFs and does have a significant impact on the industry,” said Ferreri.

Mandating full compliance of U.S. trading platforms as of October 2, 2013 for all permitted transactions will impose the burden of registering market participants and capturing granular data on each party.

Since footnote 88 was not previously contemplated in the Commission’s proposed rules, implementation creates significant logistical issues and serious time pressures. “Footnote 88 says in effect that all products, including non-deliverable forwards and equity derivatives, will have to be traded on SEFs,” said Ferreri. “Footnote 88 tells natural intermediaries, that is, brokers, that if they want to execute swaps they must register as SEFs and follow SEF rules.”