Guest commentary by Jim Falvey.
Jim Falvey, general counsel for Green Key Technologies, has been an attorney in the derivatives space for over 15 years. He has served as general counsel of Eurex US and IntercontinentalExchange, as assistant general counsel for CME Group and, more recently, as general counsel and corporate secretary of R.J. O’Brien & Associates, a Chicago-based futures commission merchant. His regulatory column appears weekly in Green Key Markets’ research newsletter. To subscribe to the newsletter click HERE.
A long time ago, in a regulatory environment that seems far away, Congress passed and President Bill Clinton signed the Commodity Futures Modernization Act of 2000, better known as the “CFMA.” That legislation reformed the way that derivatives were regulated in the United States. With bipartisan support, the CFMA generally deregulated the industry and adopted a core principal approach to regulation, replacing a regime that was very prescriptive and costly for market participants and consumers. One of the key aspects of the CFMA was the statutory delineation of trading facilities through which futures and options on futures, as well as over-the-counter (“OTC”) products could be traded. The CFMA formalized and approved of the operation of three types of facilities: (i) Exempt Commercial Markets (“ECMs”) for OTC transactions only; (ii) Designated Contract Markets (“DCMs”), which are fully regulated futures exchanges and (iii) Derivatives Transaction Execution Facilities (“DTEFs”), which were intended to fit between ECMs and DCMS by providing an intermediate or “lighter touch” level of regulatory scrutiny from the Commodity Futures Trading Commission (“CFTC”). DTEFs never took off, however. There was no benefit to trading on a DTEF for a market participant – it was simpler to either trade on a fully regulated exchange or to be exempt.
Fast forward 10 years to 2010 when Dodd-Frank became the law of the land. Lawmakers once again attempt to create another new category for trading activity known as swap execution facilities (“SEFs”). Like DTEFs before them, SEFs are supposed to fill a gap in the regulatory world of derivatives. In the case of SEFs, they can only provide access to the OTC/swaps markets. These entities have (or should have) a slightly lighter touch regulatory regime than DCMs, but are subject to limits as to eligible traders – only “big” entities or “eligible contract participants” (“ECPs”) – and products that may be traded (no futures or options on futures, only swaps).
Thus far, there has been interest in SEFs from market facilitators and infrastructure providers to create these entities. One entity, Bloomberg, has received SEF approval (obtained its license) from the CFTC (on July 30, 2013). Different from DTEFs before them, SEFs at least have initial interest that suggests a possibility of success. In order to predict this level of success, it’s worth examining the competition facing a SEF. At this point it seems clear that DCMs/regulated futures markets will be the biggest impediment to the longevity of the SEF institution. Exchanges are attacking SEFs – and attempting to gain OTC market share – through three strategies. First, they have indicated an intention to create their own SEFs to compete head-on. Second, DCMs have rolled out new “swap futures” that tend to mimic swap instruments. Lastly, exchanges are relying on block trading of futures to capture market share. In comparing the costs and benefits of a SEF against an exchange’s block trading facility, it’s difficult to see a SEF gaining material market share in any significant product.
First, what is a block trade? The Chicago Mercantile Exchange defines a block trade as: “a privately negotiated futures, options or combination transactions that meet certain quantity thresholds which are permitted to be executed apart from the public auction market.” In other words, block trades are an OTC transaction that retains the benefits of an exchange – anonymity, financial safety and soundness and confidentiality without the challenges of executing a transaction on a new facility, a SEF, where the rules are still in flux and there is no liquidity.
A DCM offers everything that a SEF offers – and more. For better or worse, Dodd-Frank and the CFTC through rulemaking, have implicitly encouraged market participants to conduct OTC transactions on a DCM via a block trade vehicle, rather than execute a similar trade on a SEF. It’s more efficient and easier for market participants. So what are the downsides to using a SEF versus a block facility?
Generally, there is one area that will jump out at OTC market participants: confidentiality. One of the SEF buzzwords used by CFTC Chairman Gensler is “transparency.” While transparency is generally a good thing, there are circumstances when transparency can be negative and create an unlevel playing field. For example, an end user may want to hedge a risk and be required to go long a large quantity of a certain commodity. To put that order to a SEF where such data is made public could cause various competing traders to “get in front of” the order because the price of the commodity will likely go up. In a sense, it’s a modern day version of legal front running. In the block world, such a scenario cannot happen and is against CME rules/Advisory Notice:
Parties involved in the solicitation or negotiation of a block trade may not disclose the details of those communications to any other party for any purpose other than to facilitate the execution of the block trade. Parties privy to nonpublic information regarding a consummated block trade may not disclose such information to any other party…
The details of pending block transactions are not known, which is a benefit for large institutional hedgers that don’t want details of their trades subject to the market. It’s also more in line with OTC market experience and expectations.
Additionally, SEFs are required to offer certain market transparencies in a multiple-to-multiple facility for execution of swaps. For example, brokers and dealers that use a SEF order book for matched customer orders are subject to a time delay or resting period (generally 15 seconds) where the orders are exposed to the open market. Blocks on a DCM in a futures market have no such requirement. Along those same lines, if a SEF uses a request-for-quote (“RFQ”) system, each request must be made to at least 3 participants (with a one-year phase-in period where each request must be made to at least 2 participants). Additionally, as to RFQs, a SEF is required to communicate to the requester all resting bids and offers pertaining to a swap for which an RFQ has been made. Once again, these rules don’t apply to blocks on DCMs, which are allowed to keep details of a block trade anonymous until executed.
On an expense point, the CFTC has mandated margin requirements as follows: a one-day liquidation for all futures and energy/metals/commodity-based swaps, but five-day liquidation for all other swaps, essentially all financial swaps. This approach to margin, which itself was the subject of litigation filed by Bloomberg against the CFTC (and was subsequently dismissed), disadvantages economically similar (if not dentical) transactions on SEFs versus DCMs. It is without doubt that the increased margin on SEFs will deter market participants from using these vehicles in favor of block transactions on DCMs.
Additionally, the CFTC issued block rules for transactions on SEFs that are much more cumbersome than DCM block regulations. Among other things, the CFTC mandated via formula the minimum size of block transactions, as well as the maximum time period for reporting (15 minutes). As the law currently stands, DCMs are free to create their own block rules including reporting time, minimum size of a transaction, products on which block trades will be available, etc.
The SEF/swap trading regime carries with it a requirement for many entities to register as Swap Dealers or Major Swap Participants, which are onerous regulations that only apply in the swaps world – not futures. The SEF recordkeeping rules are cumbersome as well. These regulations create a moat around SEFs that will keep out potential customers.
We won’t need a substantial period of time to determine the fate of SEFs. I suspect that we will have a decent idea within a year if they will gain any traction. As things currently stand given the uneven playing field for economically equivalent products (swaps on SEF versus blocks on futures), I suspect that SEFs will go down in history next to DTEFs and lose the battle for OTC market share to block transactions on DCMs.
Disclaimer: Though Jim is currently doing regulatory work for an exchange, this paper reflects his own thoughts on the matter – not those of any exchange or market participant.