Buy-side urged to focus on swaps execution rules
New rules on
US swaps trading definitions pose potential conflicts between regulatory bodies, but the
buy-side must instead focus on solidifying agreements with clearers and monitoring impending execution rules.
Recent attention has focused on harmonising divergent definitions of swaps dealers and
major swaps participants recently unveiled by the Securities and Exchange
Commission (SEC) and the Commodity Futures Trading Commission (CFTC).
But market participants have advised buy-siders to turn their attention to changes in
derivatives execution rules and reaching agreements with central counterparties (CCPs) on clearing and
collateral across multiple instruments.
The wave of derivatives regulation is part of sweeping Dodd Frank reforms seeking to
establish clarity in financial markets after the 2008 crisis, with
over-the-counter derivatives to be centrally cleared and traded via swap
execution facilities (SEFs).
are no exact implementation dates, some of the rules have been finalised and
the remainder are expected to be set in stone in the first half of next year.
As a whole, they will constitute the most rigorous changes to derivatives
trading in recent times, and buy-side firms and will be forced to significantly
alter their swaps trading business.
“While much of
the focus thus far has been on regulatory compliance, firms will ultimately
need to re-evaluate how they approach their business to capitalise on the new
market structure,” said Sean Owens, director of fixed income and research at US
consulting firm Woodbine.
As the SEC and
CFTC finalise their respective lists for the asset classes will trade on
SEFs, the minimum number of quotes investors must source before they can
execute trades remains undecided. The
SEC will deal with security-based swaps, defined as derivatives based on a
single security, loan, narrow-based group or index of securities or event
relating to a single issuer of securities in a narrow based security index. By
comparison the CFTC will cover swaps based on interest rates, commodities and
currencies. The final rules governing SEFs are expected in November, after the US presidential election.
“The SEC has
indicated you will only need to send one request for quote out to the market, while the CFTC
want multiple quotes,” said Owens, adding that the final execution requirements
will be key for the buy-side in order to finalise agreements with multiple CCPs
and alter their internal systems so they are regulatory compliant.
in finalising rules for the US$648 trillion swaps market are manifold, with the
number of quotes sourced by users of SEFs determined on a per-instrument basis,
depending on current liquidity profiles.
Bradley Wood, a partner at capital markets consultancy GreySpark Partners, the delay in determining execution rules stem
from difficulties encountered by the CFTC and SEC in dividing swaps products responsibilities.
“The lines can
be blurred over who has authority over a specific transaction. Issuing quotes
for a CDX credit default swap (CDS) index, with an index underlier will be regulated by the CFTC, however for an individual CDS, it will be the SEC, which has a vanilla bond underlier. Ideally those
rules should be in sync, but that might not always be the case,” Wood said.
Divergent use of terminology between the two agencies had also pushed back
deadlines for both bodies, and left the door ajar for increased lobbying, which
in turn fuelled further delays.
Dodd-Frank, the SEC and CFTC must impose margin and capital requirements to
ensure the soundness of swap dealers and major swap participants, however these
definitions have caused uncertainty, leading to last-minute changes.
On 12 October,
the CFTC delayed reporting for swaps under the new guidelines until 31
December. The regulator plans to reassess its definitions, which would have
included some asset managers in the same group as banks in their present form,
creating uneven reporting and compliance issues.
“In the long
term we’re expecting these definitions to converge. At the moment there’s
problems on the major swaps participant definition, so we may see the swap
dealer definition finalised first,” said Mark Israel, vice president of the
business consulting and investment management practice at services provider
Sapient Global Markets.
understanding how electronic clearing of derivatives will work, getting more
services from CCPs and managing collateral across more instruments will be key
for buy-siders looking capitalise on these changes.
managers see total transaction costs going down, but collateral costs going up,
which will happen whether it’s exchange-traded or OTC. Buy-sides will also use
consistent systems across instruments to have the same workflow for
commodities, futures trading and derivatives trading as well as interest and
credit derivatives,” said Israel.