The recent spate of applications and approvals for swap execution facilities underscores the fact that the Dodd-Frank derivatives reforms that mandate that most OTC swaps be traded on platforms is nearly a reality.
For institutional traders of interest-rate swaps and credit-default swaps, there is getting the trade right, and there is complying with applicable regulations. The former stays the same, but clearing the bar of SEF requirements as spelled out by the U.S. Commodity Futures Trading Commission is a new, complex, and non-optional challenge.
“In terms of compliance with the SEF rules, it is unlawful to trade required transactions in a bilateral mode, unless it's a block trade,” said Sam Priyadarshi, head of fixed income derivatives at asset-management giant Vanguard. “Like it or not, you have to trade required transactions on SEFs, whether you’re a swap dealer, a major swap participant, or an eligible contract participant.”
The impact of SEF regulations on the market structure for fixed-income products like bonds and interest-rate swaps could be significant. Market participants are expecting more 'electronification' of trading in these asset classes, and signs of the technological tipping points are gaining momentum.
In terms of operations, legal and trading protocol, there is still some uncertainty, although the picture is getting clearer. “For example, the CFTC requires that all trades that are traded on SEFs must have pre-trade clearing certainty,” Priyadarshi told Markets Media. “On behalf of the eligible contract participant, the SEF must get assurance from their FCM or a credit hub that the trade will be capable of being cleared.”
Regulatory documentation on SEFs is voluminous, but the CFTC recently boiled down its final rulemaking to a two-page fact sheet. Among the broad strokes of the final regulations, a SEF must provide a minimum, order-book trading functionality; required, non-block transactions must be executed using an order book or a request-for-quote system in conjunction with an order book; and SEFs must abide by acceptable practices pertaining to trading and product requirements, compliance, surveillance, operations, and financial information and resources.
For its part, the CFTC is holding fast to its October 2 deadline for SEFs to be up and running, while also indicating some limited flexibility on a case-by-case basis. "We are aware of some issues, whether it is how the pipes are between SEFs and clearing houses work, and some of the pipes between SEFs and data repositories work," CFTC Chairman Gary Gensler said at an industry conference in mid-September. "We want to sort through those things, but on October 2, we will have at least a dozen, and I think 15 to 18 SEFs that are registered,"
On-boarding Challenge
With just days until SEFs are required to be live, the question of registration, or 'on-boarding', new users has extra urgency.
“The #1 compliance issue facing SEFs is customer on-boarding,” said Shawn Bernardo, chairman of the Wholesale Market Brokers Association, Americas. “Once a SEF has been approved, it needs to begin on-boarding. From an industry standpoint, the challenge is to get them all signed up to SEFs across multiple asset classes."
"If a SEF is multi-asset class, then it has to on-board customers for all asset classes," Bernardo continued. "This is not like signing up for an exchange with one common rule book and one on-boarding packet; we’re talking about multiple SEFs, each with its own order book.”
For example, Tullett Prebon's tpSEF is a multi-asset SEF and offers SEF-compliant execution services in asset classes which are covered under Dodd-Frank, such as rates, credit indices, non-deliverable forwards, equity derivatives and commodities. tpSEF will utilize Tullett Prebon’s established electronic brokering platforms for the various asset classes.
In the U.S., the CFTC has the broadest jurisdiction over a wide range of derivatives products under the Dodd-Frank rules. The Securities and Exchange Commission, on the other hand, primarily oversees what it terms security-based swaps, which include single-name CDSs as well as CDSs based on a narrow security index.
“To the extent that SEF rules are different, then operationally it will be challenging to keep track of different sets of rules,” said Vanguard's Priyadarshi.
That has ramifications for reporting of swaps transactions. The CFTC require swap information to be reported to an SDR for that asset class "as soon as technologically practicable” following the execution of the swap, defined as 15 to 30 minutes for most transactions. The SEC requires that information be reported to an SDR “in a reasonable time,” depending on how the swap is confirmed and executed, ranging from 15 minutes to 24 hours after execution.
"It will be hard for market participants to remember whether to report a block trade in 24 hours or 30 minutes," Priyadarshi said.
There are also cross-border compliance issues. "The issue of cross-border compliance is not insignificant, insofar as it impacts U.S. asset managers managing funds that are non-U.S.-based," said Priyadarshi.
Pricing and valuation of complex derivatives is another major pain point for buy and sell side institutions, as regulations calling for greater transparency in the reporting of risky instruments get under way.
“While major deviations in valuations are unlikely in plain vanilla, transparent derivatives, significant price differences may be observed on less liquid or exotic derivatives,” said Matthew McFarland, director of business development at Chicago Board Options Exchange, in a blog post. “Lack of consensus about a particular derivative’s value requires heightened understanding of the inputs being used to calculate values and heightened knowledge about how those inputs impact a derivative’s price.”
