Swap Dealers Assess Dodd-Frank Costs

Terry Flanagan

Electronic execution “mandate” will drive up operational and technological spending for buy side firms, dealers say.

The shift from a dealer-based toward an exchange-based execution environment for swaps is facing pushback from dealers and buy side participants, with cost of execution the number one concern.

While the three-legged stool of transaction reporting, central clearing and exaction that forms the cornerstone of the Dodd-Frank Act’s Title VII has generated much discussion, the execution requirements have come under scrutiny of late by market participants.

The “Electronic Execution Mandate” will result in higher bid/ask spreads and significant operational, technological, and compliance costs, according to a report issued by the International Swaps and Derivatives Association.

Most of these costs will be borne by end users and may force some participants to withdraw from the market, according to ISDA.

“The EE Mandate us both unnecessary and counterproductive as electronic trading is already developing rapidly as users take advantage of the existing choice in execution venues,” the ISDA report said. “The EE Mandate will take away users’ choice, create inefficiencies and discourage innovation.”

ISDA and other industry groups have proposed a three-phase plan for migrating to a post-Dodd-Frank world. Phases one and two would involve setting up swap data repositories (SDRs) and implementing clearing and margin rules, respectively. Only after these first two phases were completed would the third phase—swap execution facilities (SEFs) —be implemented.

The plan envisions the first mandatory clearing requirements for buy side participants coming into effect in the second quarter of 2013. Thus, SEFs would not become mandatory until 2013 at the earliest.

The fact that ISDA is taking such a position at a critical stage of the Dodd-Frank rulemaking process underscores the antipathy of the swap dealer community to many of the proposed market structure changes emanating from the Commodity Futures Trading Commission, such as the timing of trade reporting and limitation on matching orders (known as the 15-second rule), the 5-dealer minimum for RFQ-based orders, and block orders.

“The implication of compliance is hugely underestimated, especially when it comes to buy side firms that don’t have the money or IT resources to meet regulatory demands,” Zohar Hod, vice president and head of the Americas at SuperDerivatives, told Markets Media.

“Even if financial institutions were ready by 2013, it is uncertain that regulators have a way to monitor these new clearing facilities from a compliance perspective. This three-stage proposal will need more than two years to be put into action,” Hod said.

Despite the “EE Mandate” label that ISDA is attaching to Dodd-Frank’s requirements on swap execution facilities (SEFs), the legislation doesn’t actually mandate that execution be electronic.

An SEF is defined as “a facility trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that facilitates the execution of security-based swaps between persons; and is not a designated contract market.”

The legislation recognizes that exchanges may not be appropriate for trading every product, and as a result has defined a new entity—the SEF–which is consistent with the essential market operating functions provided by interdealer brokers.

Many of the regulatory goals sought to be achieved are already within the capabilities of interdealer brokers, who already provide SEF-like services in the cash and derivatives markets.

Each of the five founding members of WMBAA–BGC Partners, GFI Group, ICAP, Tradition, and Tullett Prebon–intends to register to become an SEF, whose definition encompasses what IDBs already do.

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 “sell-side” dealers, in turn, use IDBs to offset their positions and find the other sides of trades.

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