Wholesale Brokers Criticize CFTC

Terry Flanagan

OTC interdealer brokers say that SEF rules would kill off liquidity in swaps markets.

Wholesale brokers active in the interdealer OTC markets are voicing concerns that proposed rules for swap execution facilities (SEFs) are overly prescriptive and will harm liquidity.

“The U.S. market for interest-rate swaps will become extremely thin and liquidity would completely dry up,” said Michael Gooch, chairman and CEO of GFI Group, at Monday’s SEFCON II conference in New York.

From their decades of experience as liquidity enhances in swaps markets, interdealer brokers say that CFTC rule proposes that “betray a hidden prejudice toward electronic-only swaps execution are ill-suited to real market conditions,” said Chris Giancarlo, executive vice president at GFI Group.

A major source of friction is the derivatives industry’s view that the CFTC, in its rulemaking implementing the Dodd-Frank Act, is seeking to apply the structures and methods employed in the listed futures markets to the OTC market, when the two are entirely dissimilar.

The Wholesale Market Brokers Association of America—made up of BGC, GFI, Tullett Prebon, Tradition, and ICAP—are supportive of the SEC’s interpretation of the SEF definition as it applies to trade execution “through any means of interstate commerce,” including RFQ systems, order books, auction platforms or voce trading systems.

On the other hand, the WMBAA is concerned with the CFTC’s proposed SEF rules, which it says would restrict trading methods that are not exclusively central limit order book or RFQ for non-block, cleared trades.

The flaw with the CFTC’s approach, the brokers say, is that it’s the liquidity characteristics of a given product, not whether or not the instrument is clearing or part of a block transaction, that determines which blend of hybrid brokerage is adopted.

“If a swap trades in a highly liquid market, then central limit order book systems may work fine,” Giancarlo aid. “If the market has limited liquidity, then electronic order book systems will not garner liquidity and other methods are more suitable.”

The CFTC rule limits request for quote (RFQ) systems to those that require each quote request be submitted to no fewer than five liquidity providers.

The SEC, in its SEF rules proposal, takes a much less prescriptive stance, by allowing a market participant to transmit a quote to a single liquidity provider.

Forcing a market participant to submit quote requests to a minimum number of liquidity providers may impair the quality of execution and is contrary to Dodd-Frank, which simply requires that participants have the ability but not the obligation to send quote requests to multiple participants, according to the OTC industry.

Additionally, under the proposal, SEFs must provide a general timing requirement applicable to traders such as brokers who have the  ability to execute against a customer’s trade (internalization) or are entering a trade for two customers on opposite sides of the transaction (crossing).

Under the CFTC’s proposal, a broker would have to provide a minimum pause of 15 seconds before entering the second side (whether for its own account or for a second customer), during which time the order would be exposed to other market participants and allowing them to join in the trade.

“The 15-second requirement is extremely problematic,” said Gooch. “It would create an opportunity for traders in the cash instruments that underlie the transaction a 15-seond head start to front trade.”

Standardized cleared trades, such as energy derivatives, are the best for SEFs, said Gooch.
GFI EnergyMatch Europe, for example, provides a gateway to a number of exchanges and clearinghouses, providing customers with a range of both cleared and OTC products.

The need to connect to multiple exchanges and clearinghouses has come about as the European energy markets have become more fragmented.

EnergyMatch Europe provides a hybrid voice/electronic trading platform enabling financial institutions, hedge funds, energy companies and other market participants to view, post or trade in OTC markets.

EnergyMatch Europe is powered by Trayport, a subsidiary of interdealer broker GFI Group which provides electronic trading software for commodities such as electric power, gas, coal, and carbon emissions.

GFI Group has established a U.S. coal desk which brokers U.S. and European centrally-cleared coal swaps for domestic clients using a single screen.

The desk enables U.S. clients to trade U.S. and European centrally-cleared coal swaps using GFI’s Trayport-powered hybrid trading technology.

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