At the recent DerivCon conference, jointly hosted by ISDA and TABB, three CFTC commissioners expressed differing opinions about potential changes to current rules governing trading on Swap Execution Facilities. While all seemed to agree that changes are needed to the current proposal, they appeared to disagree on the urgency and scope. TABB Group head of derivatives research Russell Rhoads examines the commissioners’ comments and how they might influence the regulatory process.
Late last month TABB teamed with ISDA to put together the annual DerivCon conference. DerivCon covered a wide variety of topics, but all the panels tended to gravitate toward the potential changes for rules governing Swap Execution Facilities, or SEFs. In fact, the first panel was billed as, “SEF Rules and Beyond.”
In addition to six informative panels, we were lucky to have three different CFTC commissioners give individual addresses to a packed audience. Both Brian D. Quintenz and Dan M. Berkovitz spoke during the day, with CFTC Chairman J Christopher Giancarlo speaking at the end of the conference, having just arrived from meetings in Europe.
For those new to the term, a Swap Execution Facility, or SEF, is the result of a push to move trading of financial swaps from over-the-counter to a venue that offers more transparency for reporting, clearing, and settlement. A good portion of financial swaps activity has moved onto SEFs, but like any new regulatory mandate, there have been some issues along the way.
What was interesting about the three speeches was that they expressed differing opinions about potential changes to current SEF rules. Before diving into each of the commissioner’s comments, we can get some insight into the mindset of the attendees. Throughout the day several attendee polls were taken, with fairly good participation. The first question of the day was: “Do you believe a change to the SEF rules is needed?”
Source: DerivCon 2019 On-Site Survey
Note that nearly three out of four DerivCon attendees (who responded to the poll) felt some changes were needed. Responses to the other question relating to SEF rules – “Will allowing more flexible methods of execution lead to increased volumes trading on SEFs?” – had a similar breakdown:
Source: DerivCon 2019 On-Site Survey
The second question shows that a good majority of conference participants feel that the result of new SEF rules would be an increase in volumes being traded on SEF. This is a major goal of the CFTC with respect to Swap Execution Facilities; more volume on SEFs leads to less systemic risk related to financial swaps.
Brian Quintenz was the first of the three CFTC commissioners to speak at DerivCon. One of his early statements – “The rules governing trading must reflect the players, their objectives, the markets, and the products. Marketplaces are not one-size-fits-all; neither should be our rules.” – summed up many of his comments. He went on to note that the final 2013 framework for SEF rules heavily relied on the regulatory framework used for futures markets. The new proposed rules will stop trying to squeeze the swaps market into a regulatory model designed for another asset class, he suggested.
Quintenz added that there are issues with the current Made Available to Trade (MAT) process, which he considers broken. The proposed SEF rule changes would eliminate the current MAT process. He said that in 2018, 54% of all SEF trades were non-MAT trades that were voluntarily traded on-SEF.
With respect to methods of execution, Quintenz pointed out that order books have not evolved as envisioned. Requiring all SEFs to maintain and operate order books imposes an unnecessary, significant cost on these platforms. Under the latest proposal, while SEFs must offer multiple-to-multiple trading, they may offer any mode of execution they wish for any swap, whether it is voluntarily or mandatorily traded on-SEF.
Quintenz’s final comments were about a hot button topic: pre-trade communication (see survey results below). The current proposal aims to move price discovery onto SEFs by requiring all pre-execution communications for MAT transactions to occur through SEF facilities. This means that parties no longer can negotiate terms bilaterally or through brokers. He noted he is open to hearing from market participants about how pre-execution communications for MAT transactions could be accommodated in a way that would not impede liquidity formation and pre-trade price discovery on SEFs.
Source: DerivCon 2019 On-Site Survey
Dan Berkovitz was the second of the commissioners to speak at DerivCon. His comments were a bit more reserved with regard to making changes to the current SEF rules. Early on he stated: “We should not make fundamental changes to our regulations where the data indicates that the regulations and markets are functioning well and achieving their intended purposes.” He also noted that the swap trading rules have led to an increase in competition, more electronic trading, better price transparency, and lower spreads for swaps traded on regulated platforms. He did acknowledge four areas that should be reformed: expansion of floor trader registration, abolishing name give-up, enabling average pricing, and fixing the leverage ratio.
Expansion of floor trader registration could result in an increase in the number of principal trading firms involved in the swaps market. This would offer a boost to liquidity, especially during periods of market stress, as CFTC studies have shown that principal trading firms have been an important source of liquidity during periods of market stress.
Name give-up is a deterrent to non-dealer market makers and buy-side firms that would like to participate in what are now dealer-only markets. Their identity is shared in some anonymously traded and cleared swaps. Berkovitz believes that name give-up should be abolished.
Average pricing is a common method used by investment managers to allocate trades across different accounts. This sort of functionality is not possible for many swaps traded on SEFs and as a result, investment managers may shy away from using these products. A lack of participation by the investment managers excludes an important source of liquidity. Berkovitz believes a solution should be developed to enable average pricing for buy-side swap trades.
A provision called the supplemental leverage ratio (SLR) requires banks to hold an amount of highly liquid capital determined by the total assets held by the bank. The current rules require a bank FCM to count margin as bank assets even though these funds cannot be used as leveraged. Berkovitz believes rules should be revised but ensure that bank clearing requirements are adequate from a risk perspective and do not discourage the provision of clearing services by bank FCMs.
The last session of the day was delivered by chairman J. Christopher Giancarlo. He started out noting that he has spoken at both the 2018 and 2019 DerivCon events and also presented at five of the eight SEFCON events, the predecessor to DerivCon.
Giancarlo also reminded the audience that he had been in New York a few weeks earlier, meeting with major market participants in the global swaps market. He said every firm he met with expressed a desire to address the new SEF proposal in good faith and in a positive spirit. One common theme of the feedback was that the current framework is flawed and would benefit from substantial revision. Another persistent theme, which was more subtle, is that there seems to be some regulatory fatigue. With a feeling of regulatory fatigue and current trading conditions healthy, there was some feedback to leave the status quo as is.
Giancarlo did note that before the financial crisis, one of his predecessors proposed changes to OTC swaps at a time of relatively healthy markets. She was attacked by those who preferred the status quo, including by other regulators who represented the same party. Nothing was done then, and the crisis of 2008 followed this inaction. Giancarlo said he does not want to look back in some future crisis and say that we should have fixed the SEF rules when they could have been fixed.
The commentary period for proposed SEF rule changes ends Friday, March 15. We will know more about the consensus feeling of the CFTC after comments have been digested. The commissioners expressed different areas of concern, but all seemed to agree that changes are needed to the current proposal. They have been open to hearing from industry participants, and it seems that they are taking this feedback seriously. The result should be a new set of rules that industry participants agree are an improvement. Also, the industry hopes this is a final instance of regulatory changes and that the end of regulatory fatigue is near.
Transcripts of each commissioner’s speech may be found at the following links: