May 16, 2013
Today, the Commission votes to establish a new trading venue, a Swap Execution Facility (SEF) that will allow market participants to access a more transparent market and offer innovative trading opportunities. Unlike the futures exchanges which are tied to a single clearinghouse, trades executed on SEFs can be cleared at different clearinghouses, which will provide a new competitive execution space. For these reasons, I have always had high hopes for SEFs.
I am pleased that the final rule has been revised to soften many of the proposed rough edges and should allow for a smooth transition to this new trading environment.
The final rule allows for a streamlined temporary registration process to ensure that SEF platforms are not disadvantaged by regulatory delays that could stifle competition or provide a first-mover advantage. However, instead of “rubberstamping” SEFs’ applications, a better approach would have been to conduct a more substantive, but limited review of applications by coming up with a Checklist that contains specific requirements and that takes into account work already done by the National Futures Association in reviewing the SEFs’ systems and rulebooks.
I am also cautiously optimistic about the Commission’s commitment to revisit the SEF rule and other Commission’s rules to address regulatory conflicts with foreign jurisdictions. Such regulatory disparities will discourage U.S. and foreign traders from doing business in the United States and prompt them to move their businesses to foreign jurisdictions with a less restrictive trading environment. I am pleased to have the commitment of Chairman Gensler who stated his intention to revisit the SEF rule if it proves to conflict with international regulatory requirements making U.S. platforms uncompetitive or disadvantaged as a result of this rulemaking.
For SEFs to be successful, the Commission must be faithful to the express directives of Dodd-Frank and implement rules that are clear and promote efficient and fair trading.
As I explain below, the Commission’s rules have fallen short of these objectives.
The Rule’s Requirement to Send a Request for Quote to Three Market Participants is Not Supported by Law.
Dodd-Frank seeks to “promote the trading on SEFs and to promote pre-trade price transparency in the swaps market.”1 To advance these objectives, the rule must permit SEFs to offer flexible execution platforms that ensure pre-trade price transparency, but at the same time, allow participants (buy-side, sell-side, commercial firms) to execute various products with different levels of trading liquidity at the price acceptable to them.
Thus, the success of a SEF is determined by whether it will be able to meet the liquidity needs of various market participants. Although the rules allow a Request for Quote (RFQ) to accommodate transactions in less liquid products to the extent that such products are determined to be made available to trade as provided in the Made Available to Trade rule,2 I am concerned that the requirement to broadcast a quote to at least three market participants is not supported by the statute and is not based on data analysis.3
One way for the Commission to assess trading liquidity on a SEF and make necessary adjustments to the RFQ requirement is to analyze transaction data that the Commission now receives from Swap Data Repositories (SDRs). Over time, as liquidity increases and the market feels more confident about SEFs, there will be a natural progression for market participants to migrate to more centralized execution platforms and the role of the RFQ may be significantly reduced. But again, the Commission should not come up with an unsubstantiated number and declare it to be the law. Instead, the Commission must make such determination based on an evaluation of the SDR transaction data.
The Rule Should Have Provided Further Clarity Regarding Voice Execution.
SEFs, by definition, may execute swaps "through any means of interstate commerce."4 As I mentioned before, I strongly support the use of various methods of execution, including voice, to foster a competitive trading environment on a SEF. I am pleased that the final rule acknowledges the “any means of interstate commerce” clause and provides for a role of voice and other means of execution. However, I remain concerned that although the preamble to the rule provides an example of a voice-based method of execution, the rule text does not expressly allow for voice and other execution methods.5 A better approach would have been to add voice to the rule text as the third method of execution on a SEF.
The Rule Should Have Provided Clarity Regarding Exchange of Swaps for Related Position Transactions
For some unknown reason, the draft rule prohibited trades involving an Exchange of Swaps for Related Positions (ESRPs). Yet again, such ban would have caused the pendulum of the Commission’s regulations to continue its swing toward futures trading as the Commodity Exchange Act (CEA) expressly allows for bone fide Exchange of Futures for Related Positions transactions.
The Commission sought to ban ESRPs transactions because they were not expressly allowed by the CEA. Just because these transactions are not mentioned in the statute, they don’t have to be banned by the Commission’s rules.
I am glad that in the final rule, the Commission took a more reasonable approach and now has committed to entertaining requests from market participants to permit off-exchange trades where swaps are components of exchanges of swaps for physicals transactions.
For the reasons stated above, I reluctantly concur with the decision of the Commission to approve this final rule.
1 CEA § 5h(e).
2 Commissioner Scott D. O’Malia Dissenting Statement, Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade under Section 2(h)(8) of the Commodity Exchange Act; Swap Transaction Compliance and Implementation Schedule; Trade Execution Requirement Under Section 2(h) of the Commodity Exchange Act (May 16, 2013).
3 A SEF is defined as a “trading system . . . in which multiple participants have the ability to . . . trade swaps by accepting bids and offers made by multiple participants in the . . . system, through any means of interstate commerce.” CEA § 1(a)(50).
4 CEA § 1(a) (50).
5 Commission Regulation § 37.9.
Last Updated: May 17, 2013