The euro swaps surprise

As surprises come, it should have been a non-event. On March 18, Swedish clearing house Nasdaq OMX announced it had been authorised as a central counterparty (CCP) under the European Market Infrastructure Regulation (EMIR), the first in Europe to get the regulatory nod of approval. Clearers had to submit their applications by September 15 last year, and national authorities had a six-month limit to consider them once they were confirmed as complete, meaning the authorisation was well in line with the schedule outlined by the European Securities and Markets Authority (ESMA).

Nonetheless, the announcement caught the market completely unawares, and has led to a situation where European derivatives users are unsure how to price and risk-manage euro-denominated interest rate swaps, the largest segment of the interest rate derivatives market.

How did this happen?

It all boils down to the oddly named and much misunderstood frontloading requirement under EMIR. Frontloading is a bit of a misnomer – it actually refers to a requirement to backload certain derivatives transactions to a CCP, specifically those trades conducted between the point in time ESMA is told a clearing house has been authorised to clear certain derivatives classes and the start of a clearing obligation for those products.

The problem arises because it’s uncertain which trades will be captured by this requirement, and when. Once ESMA is notified of a CCP authorisation, it has six months to conduct a consultation and draw up regulatory technical standards for each class of products it thinks may be suitable for mandatory clearing. The European Commission (EC) then has up to three months to endorse the standards, before they pass to the European Parliament and Council of the European Union, which have up to two months to accept the rules if they haven’t been modified by the EC and up to six months if they have. The rules are then published in the official journal, and come into force 20 days later.

According to a time line published by ESMA last year, the earliest a clearing mandate will come into effect after a CCP is authorised is nine months; the latest is 16 months. But there could be phase-ins written into the rules that extend the start date beyond that.

This all matters because Nasdaq OMX doesn’t just clear the smaller Scandinavian currencies – it also clears euro interest rate swaps. That means the clock is now ticking, and any euro swap transacted by a European participant from March 18 onwards may need to be backloaded to a CCP at some unknown time in the future.

This creates some real risk management headaches for European derivatives users. Should individual trades now be treated as cleared, non-cleared, or a mixture of both? It’s virtually certain a clearing mandate will apply for euro interest rate swaps at some point, but it’s not clear when. The situation is even less clear for other, less liquid products – ESMA may decide after its consultation period that some instruments are not yet suitable for mandatory clearing, particularly if they are only cleared by a single CCP.

Market participants had hoped regulators would provide further clarity on frontloading before the first CCPs were authorised. Without this guidance, derivatives users can’t be sure whether any single trade will ultimately be subject to frontloading or not. That’s why the approval of Nasdaq OMX came as such a shock.

Further clarity will come at some point. But the sooner the better. Until it does, uncertainty will continue to hamper risk management in the euro swaps market, making it more difficult for end-users in Europe to implement the hedges they need.

Progress, of a sort

Eight months on from the much-heralded “path forward” agreement that set a roadmap for how US and European regulators would deal with cross-border regulatory issues, the fruits of the new cooperative approach have started to emerge. In February, the Commodity Futures Trading Commission (CFTC) issued conditional no-action relief allowing US entities to continue trading on European multilateral trading facilities that haven’t registered as swap execution facilities, so long as those platforms meet requirements that are identical to those applied in the US.

It may not have been exactly what some European venues were hoping for, but this represented notable progress. At one point last November, following two clarifications by the CFTC that seemed to extend US rules further than ever before, it looked like the path forward would become a road less traveled.

There’s still a huge number of cross-border issues that need to be tackled – among the most urgent, Europe’s equivalence determinations for US central counterparties (CCPs). Under the European Market Infrastructure Regulation (EMIR), European banks would not be allowed to act as clearing members of any CCP in a non-equivalent jurisdiction, while Europe’s Capital Requirements Regulation prevents them from applying the lowest possible 2% risk-weight for cleared exposures at those venues. Together, these rules could have a devastating impact on the business of any non-equivalent clearing houses.

A comparison between US and European clearing rules throws up a number of seemingly intractable inconsistencies – for instance, a one-day margin period for futures contracts under US rules less onerous than the two days required under EMIR. Nonetheless, some have speculated that the new-found spirit of cooperation between US and European regulators may allow a compromise to be reached.

That doesn’t answer what happens elsewhere, though. Trades conducted between US and European entities account for a large portion of the cross-border universe, but there are plenty of transactions involving counterparties from other jurisdictions too – Australia, Hong Kong, Japan, to name but three. Some regulators have set out broad parameters for equivalence or substitutability determinations, but these are imprecise and lacking in detail.

Generally, regulators agree that foreign rules should be deemed equivalent if they pursue the same outcome. But beyond a pretty clear global consensus on central clearing and reporting – both key Group of 20 (G-20) objectives and initiatives supported by ISDA and the derivatives market – the desired outcomes differ from jurisdiction to jurisdiction. Dodd-Frank, for instance, covers everything from trading, clearing, reporting and business conduct rules to broader bankruptcy and resolution proceedings. EMIR covers clearing and reporting, with trade execution covered by the revised Markets in Financial Instruments Directive, but many other countries with smaller derivatives markets have opted to tackle clearing and reporting only.

The risk is that some national regulators will approach each outcomes-based equivalence determination as a broad, like-for-like comparison of their own regulatory and legislative framework. That tactic would likely doom any equivalence process to failure. Rather, regulators need to focus on whether the core objectives set by the G-20 are being met, taking foreign legal regimes and local market practices into account.

The trouble is getting to this point, as well as having a mechanism in place to deal with any disputes. The International Organization of Securities Commissions has suggested it may be able to play a role here, drawing up a set of principles – perhaps similar to those published by ISDA last year – and intermediating in equivalence determinations. This could involve peer reviews, colleges of supervisors and regulatory visits, comparable to what the Basel Committee on Banking Supervision has in place for Basel III. It seems like a good idea, and could do much to resolve potential problems and ensure the global derivatives market continues to be just that: global.

The road to reporting consistency

road aheadEurope is about to take another big step on the road to over-the-counter (OTC) derivatives reform with the start of mandatory reporting on February 12. From that date, all derivatives conducted by European firms will need to be reported to regulators via a repository authorised by the European Union, bringing further transparency to the market – a goal that ISDA fully supports.

It hasn’t been an easy journey, though. The major derivatives dealers have been reporting to repositories for some time, well before the mandates came into force, and market participants had to meet reporting obligations under the Dodd-Frank Act last year. But European derivatives users have had to get to grips with a set of rules very different to those implemented in the US. For one thing, both counterparties to the trade have an obligation to report, creating all manner of challenges over who generates the unique trade identifier (UTI) for each transaction and how it is communicated to the other counterparty in time to meet the T+1 reporting time frame. Firms can delegate their reporting to a dealer or to a third party, but they still retain the obligation to ensure those reports are accurate. Any mistakes by the delegated party and the counterparty is on the hook – a potential liability many are uncomfortable with.

The scope of the rules is also much, much broader, capturing all asset classes without any phasing and both OTC and exchange-traded derivatives – the latter inclusion requiring huge amounts of work to adapt the systems and processes developed for Dodd-Frank. This had to be completed in a relatively short amount of time too: it was only confirmed the reporting mandate would apply to exchange-traded derivatives from day one in September 2013.

A number of technical issues have also plagued preparations. There has been little regulatory guidance on a system for UTI generation, leaving the industry to develop its own proposal. That proposal hasn’t been formally endorsed by regulators, however, causing some counterparties to develop idiosyncratic approaches. On top of that, only a fraction of the derivatives user base has applied for a legal entity identifier, a 20-digit code essential for continued trading of derivatives from February 12.

The reports themselves are also proving challenging. Several required data fields are unique to European rules, such as the type and version of any master agreement used – and this information is not currently supported by middleware providers. A lack of guidance over whether to report data subject to strict privacy laws, how to treat uncleared trades that are subsequently cleared and therefore split into two new transactions, whether the notional amount field should be updated over time, and how to deal with complex and bespoke trades where firms may use different booking models have all added to the challenges.

But there are bigger issues here: the sheer volume and inconsistency of data collected by global repositories all over the world. Commodity Futures Trading Commission commissioner Scott O’Malia frequently raised concerns last year about a lack of consistency in how US firms are reporting data and differences in how the various repositories collect their information. This is likely to get worse as more reporting mandates come online, all with their own, unique requirements, and new domestic repositories are authorised.

An initiative championed by the Financial Stability Board (FSB) will hopefully pull together all this data in a consistent format, enabling regulators to get a clear view of the market and spot a build-up in systemic risk – the original intent of the original Group of 20 mandate. The FSB published a consultation document on February 4, which outlines some of the potential models for data aggregation. But until a viable mechanism is up and running, no-one will have the full picture. Given the time, expense and resource that everyone – dealers, end-users and infrastructure providers – have put into meeting the mandates, it is disappointing a global framework for consistent data reporting wasn’t put in place by regulators from the start.

ISDA has tried to help throughout the process, proposing that the ISDA taxonomy be used as the basis for product identifiers and coordinating work on the industry UTI proposal. A further initiative will also help increase transparency, with the launch of a new portal (see screenshot below) that pulls together information currently available on interest rate and credit derivatives in a easy-to-digest and transparent format. You can access the ISDA SwapsInfo website by clicking here.

SwapsInfo for IRD

Market fragmentation is becoming a reality

fragmentation

The global nature of the derivatives market has long enabled users to manage their risk efficiently. This is something ISDA has championed throughout its history, and it’s been our single biggest concern over the past few years. Thankfully, the Group of 20 (G-20) nations shared this concern when setting their roadmap for derivatives reform in September 2009.

Nonetheless, derivatives users have been warning for some months now that the rollout of the US swap execution facility (SEF) regime, and the extraterritorial reach of those rules, would lead to market fragmentation, with separate pools of liquidity emerging for US and non-US persons. Evidence is now emerging that this is indeed the case.

Research published by ISDA clearly shows that European dealers have been opting to trade euro-denominated interest rate swaps with other European counterparties since the start of the SEF regime on October 2, 2013. Based on the volume of trades cleared at LCH.Clearnet, approximately 90% of European interdealer activity in euro interest rate swaps is now being traded with other European firms, up from roughly 75% before October. That tallies with an earlier survey published by ISDA in December, which found 68% of respondents had reduced or ceased trading activity with US persons since the SEF rules came into effect, while 60% had noticed a fragmentation of liquidity.

So, why are these rules affecting the trading habits of European dealers? It can all be traced back to the last-minute inclusion of footnote 88 within the final SEF rules, agreed by the Commodity Futures Trading Commission (CFTC) last May. That footnote essentially required all multiple-to-multiple trading platforms to register as SEFs, even if the products they offer aren’t subject to a trade execution mandate – an inclusion that sent a number of venues scrambling to submit their applications before the October 2 deadline. Combined with that was uncertainty about final interpretive guidance on the cross-border application of Dodd-Frank, published in the Federal Register on July 26. While the treatment of SEFs wasn’t explicitly covered, a number of non-US electronic trading platforms interpreted the guidance to mean they would need to register with the CFTC if any US person – including foreign branches of US banks – traded directly or indirectly on their venue.

Given the complex registration process, and the need for SEF customers to sign lengthy end-user agreements, a number of non-US platforms decided it was simply easier to ask US participants to stop trading on their platforms, or to split their businesses between US and non-US liquidity pools. The latest ISDA research shows this has become a reality.

Less clear is how this has affected over-the-counter derivatives markets. A fragmentation of liquidity could lead to less efficient pricing in certain markets, as well as greater volatility – something the G-20 stated it wanted to avoid in September 2009. According to the December ISDA survey, 46% of respondents said the fragmentation had led to different prices for similar types of transactions, but this trend may become more pronounced over the next month. While trading platforms have had to register as SEFs since October, US derivatives users haven’t been obliged to use them – they could continue to trade by phone or via single-dealer platforms. That will change on February 15, when the first trade execution mandates come into force. From that point, US participants will be required to trade those interest rate derivatives subject to made-available-to-trade determinations on registered SEFs or designated contract markets. Non-US entities won’t – and will probably continue not to want to.

Global regulators have talked a lot about the need for cooperation to ensure a consistent application of the new regulatory framework, and to avoid fragmentation and less efficient markets. This latest evidence suggests fragmentation is happening, and that can’t be a good thing.

Why regulatory transparency doesn’t get the “all-clear”

A recent speech by Benoit Coeuré, a member of the ECB Board of Executives, sheds some light on a key issue in the OTC derivatives markets: regulatory transparency.

It’s an issue on which ISDA and market participants have spent a lot of time and resources – largely to good effect, as the trade repositories we helped establish gave policymakers a clear view of risk in the system.

Recent developments, though, threaten to undermine progress that has been made.

Mr. Coeuré asks an important question about transparency in his speech: “Does…the supervisor responsible for the supervision of a large cross-border financial institution at a consolidated level have direct and immediate access to information on OTC derivatives transaction that encompass all transactions entered into by all entities of this group? Is the information accessible, in other words can it be easily aggregated across trade repositories and jurisdictions?”

He then goes on to say: “My answer would be a clear no!”

And we agree.

Mr. Coeuré went on to discuss privacy laws, blocking statutes and indemnification clauses in several jurisdictions which restrict access to the detail of OTC derivatives transactions; the inability to aggregate data across trade repositories and jurisdictions; and differences in the type and level of information required for reports across jurisdictions. He ultimately broke the problem into three main issues: information gaps, data fragmentation across trade repositories and jurisdictions and obstacles impeding authorities’ access to data.

As the ECB official points out, the Financial Stability Board, assisted by the CPSS and IOSCO, has only very recently begun a feasibility study on various approaches to address shortcomings in the global regulatory reporting landscape (a global repository aggregator being one approach).

These problems were predictable, and were predicted. The OTC derivatives market has been a global one from its inception. The only way to capture this activity is single centralized trade repositories by asset class. Proliferation of trade repositories – within different regions and globally – leads to fragmentation and possible duplication of the information gathered. As such it undermines the very efforts of the regulators to capture and comprehend the risk exposures that market participants want to provide and that regulators want to get.

We believe there is a lesson here. Regulators will have heard ISDA and various market participants ask “What is it you want to achieve?” when addressing regulatory proposals and wishes. This is not a rhetorical question. Regulatory (or quasi-regulatory) processes where there is a real, interactive debate with industry and other interested parties – such as those which first enabled development of trade repositories – are healthy, and achieve results. They create shared understanding of regulators’ goals, and help everyone to build towards them.

There’s still a lot of work to be done on derivatives regulation – on global reporting taxonomy, for example (which must involve an open and interactive dialogue between regulators and industry). We want to solve these problems too, and want to be able to help regulators to do so.

Should I stay or should I go?

Everyone knows that two of the busiest days around the office are the day before you leave on vacation and the day you return. For some of us at ISDA today is getaway day, but that doesn’t mean there isn’t time to spare a few thoughts on the current state of the derivatives markets.

We had something of a “July Surprise” with the announcement on July 11 that peace was at hand between the CFTC and European regulators on cross-border derivatives regulation. We viewed that announcement, as many people did, as a positive development and a serious attempt to advance the discussion of global regulation of a global business.

As is often the case with broad pronouncements, however, the detail is in the detail, to coin a phrase. The next day the CFTC provided its final guidance on cross-border issues and additional time for compliance under an exemptive order. It is clear from the detail that the process of determining substituted compliance is going to be a critical one. It will be important to get both the substance and the process right. You will be hearing more from ISDA on this in the days ahead.

The CFTC work plan for derivatives is largely complete, with the finalization of the cross-border guidance and the publication earlier in the summer of SEF rules and related rulemaking. We will continue to work through the implementation challenges our members face, including the third wave of mandatory clearing in early September, but the drumbeat of deadlines is fading on the US front.

But don’t think it will be a vacation from here on out — far from it. Still, at least there will be a change in locale — Europe in particular, but all over the globe as well.

Europe is considering its approach to mandatory clearing and our various product steering committees are reviewing ESMA’s discussion paper. Confirmations and portfolio reconciliation face mid-September deadlines. And the European approach to the G20 commitment on execution will be hashed out over the course of the Fall through the consideration of the Markets in Financial Instruments Regulation in the trilogue process. We will be actively engaging with policy makers to identify areas with particular market sensitivity.

Globally, we are expecting approval by the G20 of the proposals on margin for uncleared derivatives. We have written extensively, both in derivatiViews and in submissions to regulators, about our significant concerns with the proposed initial margin requirements. It seems clear that initial margin in some form and quantum will be required, so we are also working on the development of a standard initial margin model to facilitate the introduction of any initial margin that might be required. Whatever the G20 decides will need to be implemented at national levels, so this issue is going to be on the front burner for months to come.

There are other things that await your return from vacation — major regulatory capital proposals, consideration of benchmarks, new credit derivative definitions, to name a few. In a few weeks, as summer ends (or winter for those of you in the southern hemisphere), and you feel the need to quickly get up to speed on all the developments affecting derivatives, consider attending our annual regional conferences in New York or London in September or in Asia in October. Details are on our website.

Wherever you may be headed—or even if you are staying put—safe travels and we look forward to your continued involvement and support.

Surf’s Up!

Summer is here and the beaches are open in the US, Europe and elsewhere. How appropriate then that the second wave of mandatory clearing has now hit US shores.

This is an important development, and marks a big step forward in reducing counterparty credit risk through clearing, which is one of the two major strategic G20 initiatives to reduce systemic risk.  (The other – increased regulatory transparency – is being accomplished through trade reporting and the establishment of trade repositories.) At this point, the vast majority of interest rate and credit default swaps in the US must be cleared.

The first wave of mandatory clearing in March covered the (relatively) low hanging fruit, entities like dealers and active traders that were already clearing or well-prepared to do so.

The June wave of mandatory clearing covers a wider swath of the asset manager and fund communities. The focus has been on putting in place legal documents and operational arrangements that will enable these entities to clear the interest rate and credit default swaps for which clearing is now mandated. Dealers, clients and regulators will be closely observing this experience as many of these entities will be clearing trades for the first time.

ISDA has worked with its members to address the challenges of this new wave of mandatory clearing. The phased implementation adopted by the CFTC was an outgrowth of discussions between ISDA and the CFTC dating back to 2011. The documentation that firms are using is based on the FIA-ISDA Clearing Addendum published a year ago. And we announced on Monday that four dealer firms have announced their support for the Clearing Connectivity Standard (CCS) we are developing with Sapient to facilitate reporting of cleared swaps. We believe CCS provides a sound basis for reporting and communication, initially here in the US and, in due course, around the world.

And the clearing tide is rising in other parts of the world. ISDA is working with its members and regulators in other jurisdictions to anticipate those developments. This week we announced, together with the Futures and Options Association, the publication of a clearing addendum for use in the European context in clearing arrangements that use a principal-to-principal arrangement, instead of the agency model (FCM) required in the US. While driven by the upcoming clearing requirements under EMIR, the ISDA-FOA addendum can be used in any jurisdiction where the principal arrangement is used.

The final wave of mandatory clearing in the US arrives in September. The experience of the first two waves and the efforts of ISDA and its members to date will, we believe, position the swaps industry well as that next wave comes ashore.

And let’s not lose sight of the broader landscape of regulatory reform and the progress that has been made.

The September 2009 G20 commitments in Pittsburgh provide the contours of reform, with clearing and trade reporting foremost among them. Sure, there are issues firmly on the horizon yet to be fully resolved (SEF implementation, MiFIR, extraterritoriality, initial margin, to name a few). But the progress made on clearing and trade reporting is significant, something we’ll be reporting on soon in our semiannual market analysis.

So that’s the lay of the land – and the sea – of derivatives regulatory reform.

On the (broken) record…

Last Monday, ISDA submitted its response to the second BIS/IOSCO consultation on “Margin requirements for non-centrally cleared derivatives”. The second consultation asked market participants to comment on two specific areas: the treatment of physically-settled FX transactions, and the question of re-hypothecation. At the same time, it asked for comments on the newly proposed phase-in of initial margin (IM) requirements, and the accuracy and applicability of the results from the Quantitative Impact Study (QIS) conducted as part of the first consultation.

Here are some of the broad themes that emerge from the second consultation:

First, the regulators’ stance towards IM requirements remains unchanged. The IM proposals contained in the second consultation are in line with those of the first consultation, calling for imposing a universal two-way initial margin (IM) requirement on all covered entities (all OTC derivatives participants except for sovereigns, supranationals, central banks and non-systemically important corporates). However, the second consultation excludes entities with aggregate notional amounts of less than €8 billion notional outstanding during the last three months of the preceding year.

Second, while the regulators seem to acknowledge the potential impact of the IM requirements on liquidity, they attempt to mitigate these negative effects by:

  • Phasing in and gradually applying the requirements starting in 2015 with the largest entities (those with more than €3 trillion notional during the last three months of the preceding year), and gradually capturing all covered entities by 2018;
  • Allowing limited netting to be used in connection with the standardized table method;
  • Contemplating (and asking participants about) the possibility of some form of re-hypothecation.

Third, the published QIS results confirm ISDA’s estimates as to the quantum of the proposed IM requirements. If nothing else, the QIS results indicate even higher quantities of required collateral to meet the IM obligations (from $1.7 to roughly $2.2 trillion, if all covered entities use internal models – and from $0.8 to $0.9 trillion – and a potentially higher number, depending on how the €50 million threshold is applied1).

Indeed, reflecting the regulators’ anxiety as to the quantum of the IM proposals, there are some encouraging morsels in the stew, such as the effort to exempt a number of smaller entities. Unfortunately, even in this case, the metric used is notional amounts. Since that is not risk sensitive, it is inconsistent with the overall objective of reducing systemic risk. It would make more sense if the metric used was risk sensitive and, as we suggest in our response, took into account the hedging activities of the entity.

Most importantly, if one takes all of the above into account, the thrust of the consultation and the industry’s response remain more or less unchanged. If the proposed IM requirements go ahead as proposed, the sheer quantum of them is likely to cause irreparable damage to market liquidity and to the general economy. We have repeatedly listed these arguments before in various shapes and forms; in our March paper Non-Cleared OTC Derivatives: Their Importance to the Global Economy; in last November’s presentation Initial Margin For Non-Centrally Cleared Swaps: Understanding the Systemic Implications; and also in a shorter take in a media.comment post from January.

Moreover, as our research in the collateral space expands, so does our anxiety as to the potential effects of the IM proposals to the general economy. Collateral serves a fundamental function in the secured financing market and is a source of liquidity as it is a substitute for money/credit. Removing trillions from the collateral market, however phased-in such requirements are, undoubtedly will have a negative effect on the economy.

And if those adverse effects are not enough, there’s another factor to consider: the IM requirements are highly pro-cyclical, hitting participants at the worst possible time when everyone is on a quest for liquidity. In an effort to enhance systemic resiliency by reducing counterparty risk, we may be introducing other risks, such as liquidity and economic risk, that may make it harder to achieve a more resilient system.

So, for the record, that’s where ISDA stands on the IM issue. If the record sounds a little broken because we have been playing it a lot recently, that’s because we have. These are important issues and it’s clear that their impact needs to be fully assessed before they are finalized and implemented.

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1 The new consultation seeks to apply the €50 million threshold on a consolidated basis, potentially neutralizing the benefit this exemption, as the threshold gets divided by the number of entities belonging in the consolidated group.

All Quiet on the Clearing Front

A milestone week for OTC derivative clearing has come – and almost gone. Unless you are immersed in Dodd-Frank (like we are) you probably didn’t even notice.

And that’s a good thing.

Starting this past Monday, swap dealers and active funds* in the United States have been required to clear various interest rate swaps and CDX credit trades. No one would guarantee beforehand that things would go smoothly, but at this point we can say that everything went pretty much according to plan.

At the end of the first day of clearing we reached out to our members to hear about their experiences, particularly any significant issues they may have had. As the adage goes, silence is golden. No issues of any particular concern were raised and three more days of smooth sailing on the clearing front only reinforces that view.

Deadlines always help to focus attention and we know from our members – buy side, sell side and CCPs – that they were working hard through the past weekend to get systems and documentation up to snuff for Day 1 of Clearing. Perhaps a few even listened to our urgings from a month ago. All that hard work paid off.

One reason this first wave of clearing went smoothly is that much of the clearing to which the mandate applied was already underway. Dealer-to-dealer trades in the affected product types have been cleared for quite some time. At least some of the active traders had tested the waters on clearing. This reflects the industry’s commitment to the key tenets of regulatory reform that reduce systemic risk, including the reduction of counterparty credit risk through clearing.

With one deadline successfully met, market participants are looking ahead to several new ones. External Business Conduct Rules (EBCR) become effective on May 1. The next two waves of clearing occur on June 10 (for commodity pool operators, private funds and non-dealer financial entities) and on September 9 (for everyone else, other than commercial end-users).

For the May 1 deadline, we will be rolling out our next Dodd-Frank Act protocol shortly and will be holding an EBCR webinar on Thursday, March 21 (click here to register). For the next waves of clearing we will continue to work with our members and the broader market to assist them however we can to prepare for those important dates. Those next categories of market participants facing the clearing mandate are a bigger universe than the active funds, making the education process even more of a challenge.

Future efforts will be buoyed by the experience of the first day of clearing. When it comes to the many challenges of regulatory implementation, we firmly believe that success breeds success.


* The clearing mandate also applies to major swap participants, but at this point only two firms have registered as such and neither is engaged in new trading.

Why Limit Customer Choice on SEFs?

Last week we published the results of a survey of buy-side firms on proposals to mandate how many quotes must be requested when utilizing a swap execution facility (SEF). The CFTC proposal would require a minimum of five quotes and the entire industry has been waiting to see what the final rules will say on this point.

The survey, which we conducted with the Asset Manager Group of SIFMA with additional input from the Managed Funds Association, indicates overwhelmingly that the five quote minimum requirement will mean higher transaction costs, wider spreads, constrained liquidity, exposing of investment strategies, migration to different markets and use of alternative products that are not traded on SEFs.

Is this what regulatory reform was intended to achieve?

The fact is, the creation of SEFs was intended to provide a third way of trading derivatives, fitting along a spectrum that included the traditional means of OTC derivative trade execution on the one hand and the exchange traded world on the other. Sitting in the middle of that spectrum would allow SEFs to blend the best of both worlds. If SEFs are not sufficiently different from the former or too much like the latter, we would fall short of one of the goals of the G20 and the Dodd-Frank Act.

Dictating, and in the process limiting, customer choice does not seem to us to be a good way to achieve those goals. A minimum quote requirement takes the decision out of the hands of the users of the products with no clear demonstration that better pricing, lower costs or greater liquidity would result.

And who is more able to opine on such matters than the participating firms in the survey? Asset managers, hedge funds, insurance companies, pensions, foundations, endowments, corporates and others, together holding nearly $18 trillion in assets responded to the survey. Does someone other than those institutions know better than they what suits the needs of their accounts and investors?

SEFs can and should flourish, if we get the regulatory structure right. Many firms are eagerly awaiting the final rules from the CFTC so that they can begin final preparations to register as SEFs and launch their offerings. Rigid requirements with no demonstration of benefits, such as minimum quote requirements, will only weigh down these innovative offerings.

Let’s not burden SEFs and their many potential customers before they even get up and running.