Feb 07, 2012
Available to trade or forced to trade?
Almost two-and-half years
after the G20 recommended mandatory OTC derivatives clearing and on-exchange
trading, the details of how swaps will be made available to trade are currently
being firmed up by regulatory agencies in the US and beyond. So as political
leaders’ 2012 year-end compliance deadline swings into view, how should the
buy-side expect to be trading OTC derivatives?
As pleasant as the phrase ‘available
to trade’ sounds, the measure born from the Dodd-Frank Wall Street Reform and
Consumer Protection Act is the way the federal agencies way will force certain
swaps to be traded through newly-created swap execution facilities (SEFs).
Besides broad brush strokes,
what exactly will be made available to trade has not yet been confirmed by the Commodity
Futures Trading Commission (CFTC) or the Securities Exchange Commission. While
few market participants still rile against forced on-exchange trading, there is
continued disagreement over how similar these instruments need to be.
On one side of the argument
are those – like the International Swaps and Derivatives Association – which
believe only those instruments that are fully fungible should be made available
to trade on SEFs. On the other side are those who think that as long as swaps
are broadly economically equivalent, then there’s room for the instruments to
trade electronically or on dedicated platforms. Christian Martin, chief
executive of TeraExchange, believes the line should be drawn closer to the
latter.
Late last year, the New
Jersey-based start-up launched one of the world’s first central limit order
books for OTC cleared derivatives. The SEF offers access to both underlying and
related exchange-traded instruments, as well as all cleared OTC derivatives,
including interest rate swaps, credit default swaps, energy swaps,
non-deliverable forwards and equity swaps.
At a public roundtable last
week between CFTC staff and industry experts, Martin said three years on from
the G20’s 2009 mandate, there was now less friction against the inevitability
of mandatory OTC derivatives clearing and on-exchange trading.
“The fait accompli is here
and the discourse has turned to how it should be accomplished and the granular
details of making it work,” said Martin.
Not too tight
Martin believes the purely
fungible approach to migrating swaps is far too restricting and would mean two
assets would need to have exactly the same risk measurements to be made
available to trade on a SEF. Instead, he advocates a wider definition of
economically equivalent.
“SEFs should act as the
proving ground – fact finding and collecting data – to show the CFTC which
swaps should be considered,” said Martin. “This feels more organic and client
driven than the purely fungible approach, which is more prescriptive.”
Martin also argues that if
only fungible instruments were made available to trade on SEFs, fewer
appropriate instruments would migrate. He maintains that the federal agencies understand
this, having two years ago undergone the analysis of economic equivalency for
non-fungible assets when New York Portfolio Clearing (NYPC) was set up. Then,
Martin maintains, the regulators determined that futures against offsetting
cash positions can receive margin relief at NYPC. The NYSE Euronext and Depository
Trust & Clearing Corporation joint venture began operations in March 2011,
as a clearing house dedicated to the cross margining of fixed income futures
with fixed income cash securities.
“For margin relief involving
swaps and some other asset class, you need economic equivalency, but in no way
are those assets fungible,” he said.
For budding SEFs, there are
varying degrees of readiness but Martin said TeraExchange is raring to go.
“This quarter we’re open for business,” he said. “Those of us in the SEF space
need to help the buy-side understand the new market structures that will be in
place. The right SEF can be a turn-key solution to the new environment.”
Just right
Michael Cosgrove, managing
director of strategic initiatives in commodities and energy at GFI Group – an
inter-dealer broker specialising in OTC derivatives – agreed a looser
definition than purely fungible instruments would be adequate.
“Regulators are concerned
that by defining economically equivalent as essentially [rather than strictly] fungible,
they will leave a loophole that will allow traders to alter an instrument ever
so slightly, so that it will not be required to trade on a regulated market
such as a SEF,” said Cosgrove. “This is why the definition of economically
equivalent has been so difficult to draft.”
For buy-siders, the question
isn’t just one of what they will be able to trade, but also how they will be
able to trade. At last week’s public roundtable, Cosgrove was invited by CFTC
staff to represent the Wholesale Markets Brokers Association on a panel which
discussed the issue of how OTC swaps should trade in a newly regulated market.
Cosgrove’s main message was
that the Commission should observe the letter and intent of Dodd-Frank, which
specifically permits the execution of all swaps “by any means of interstate
commerce” – including voice and electronic trading. Cosgrove believes that if
the CFTC “obeys the law”, then a far broader range of swaps will be suitable
for the ‘made available for trade’ designation that commits those swaps to
trading exclusively on regulated markets – SEFs.
“It is in the public interest
that, to the maximum extent possible, the trading of swaps takes place on
transparent, regulated markets,” said Cosgrove. “Provided the CFTC permits
regulated markets to operate as specifically prescribed in the Dodd-Frank Act,
this can be accomplished.”
Cosgrove admits many of the
current OTC swap markets can be characterised by “episodic” liquidity, but
warns against a headlong rush toward wholesale abandonment of current practice.
“It is important to realise
that wholesale brokers want the same thing as the CFTC in this regard. We want
markets to be transparent and efficient, and an electronic central limit order
book is extremely transparent and efficient,” said Cosgrove, adding “While our
member-brokers already operate some of the largest, most efficient and liquid
global electronic markets, we also operate many markets that will be destroyed
by a premature requirement to limit execution to a screen. The public will not
be served by the destruction of these markets and neither will our
shareholders.”
Originally due in July 2011,
the rules for SEFs have been delayed, following an announcement by the
Commodity Futures Trading Commission chairman Gary Gensler in September that
the final rules for SEFs would not be implemented until 2012. The regulation
had also previously come under attack from Craig Donohue, head of Chicago-based
derivatives exchange CME Group, on the basis that it does not take sufficient
account of the costs and benefits of the proposed new rules.
Bruce Love
+44 (0)20 7397 3818
bruce.love@thetrade.ltd.uk