May 16, 2013
Today’s releases promise to fundamentally restructure the over-the-counter markets (“OTC”) for swap trading, and increase pre-trade transparency and participation for many that were previously unable to access or compete for liquidity in the OTC marketplace. This is a landmark achievement for the Commission.
I believe that taken as a whole, the Commission has struck an acceptable balance in these final rules. I am certainly confident that the new execution framework recommended by the professional staff in consultation with public-interest groups, the industry, and the regulatory community over the course of the past two years or so, represents a fundamental shift away from the OTC model as it existed only a few years ago.
The benefits of this shift are many. For example, many swaps will for the first time trade on regulated platforms and benefit from market-wide, pre-trade transparency, which should improve pricing for the buy-side, commercial end-users, and other participants that use these markets to manage risk. Additionally, SEFs, as registered entities, will be required to establish and enforce comprehensive compliance and surveillance programs that simply do not exist in the swap markets today.
Another potentially significant benefit not as often discussed is the improved ability for clearing houses and their members to manage risk during times of market stress, effectuated by liquidity formation on SEFs should these platforms function as envisioned by these rules.
The final rules also will facilitate compliance with Dodd-Frank’s other derivatives reforms, especially real-time reporting, clearing, and straight-through processing. In this respect, the execution rules complement the Commission’s other efforts to streamline participation in the markets by doing away with the need to negotiate bilateral credit and other provisions in order to access liquidity. This not only benefits the end-users that the markets are intended to serve, but also new entrants that intend to compete for liquidity and now will be able to access the markets on impartial terms. In essence, the final execution rules support a transparent, risk-reducing swap-market structure under the oversight of the Commission.
Like all of the Commission’s rules, today’s releases require the Commission to make a number of policy judgments that necessarily involve trade-offs. And in making those judgments, the Commission faces the challenge of creating a new market structure on paper while being informed only by what we know, or think we know, about the swap markets today.
The Commission therefore must remain open to reassessing the policy judgments in these final rules as the markets evolve, as the Commission is provided new information, and as the Commission benefits from its experience overseeing the new SEF market structure. In short, the Commission must remain open to course correction, where necessary, and ensure that the swap regulatory regime keeps pace with the markets that it governs.
One difficult and widely-reported policy judgment concerns the required trading protocols for executing certain swaps subject to the trade-execution mandate. A significant number of commenters cautioned the Commission against imposing specific trading protocols on the marketplace. Comment letters suggested, for example, that such rules might have the unintended effect of increasing hedging costs for liquidity providers, thereby adversely affecting pricing for the firms that depend on these providers to assume risk.
Other participants have expressed concerns that relatively illiquid swap markets, like off-the-run credit, might be dislocated if the Commission tries to force immediate changes to the currently used means of execution.
These concerns, and others, have contributed to a constructive dialogue both inside and outside of the Commission. Having considered the panoply of execution issues and policy trade-offs at length, I am confident that the final execution rules before us today contain appropriately flexible trading protocols.
Furthermore, it is also my belief and understanding that if questions of interpretation arise from market participants concerning permissible trading protocols, the Commission staff should err on the side of flexibility when providing interpretive guidance.
Incidentally, “flexible trading protocols” is not code for “status quo” as some might suggest. It is not code for “pro-dealer” trading protocols. Nor is it code for “pro-buy side,” or “pro-retirees, -pensioners, -endowment-beneficiaries and -end-user” trading protocols, although I believe it is these constituencies who stand to benefit the most from this flexibility.
Instead, what “flexible trading protocols” really means is: consistency with congressional intent as it relates to swap-trade execution under Dodd-Frank, which on its own was destined to bring dramatic change to the OTC swap markets.
Again, the changes are many. Under Dodd-Frank and our implementing rules before us, every SEF will be required to have an order book, another transparency-enhancing change to the existing market structure.
But a number of important safeguards built into our rules also ensure that participants continue to have access to competitive, timely, and representative prices – as well as liquidity – when order book trading may be somewhat premature.
One such safeguard, of course, is the block-trading rule, which sets the thresholds above which certain swaps can be executed through even more flexible trading protocols. In my view, the long-awaited block rule is consistent with Congress’ intent to drive a significant portion of OTC swap activity into a multilateral trading environment. And, as a complement to the SEF regime, the block rule will for the first time usher in real-time, post-trade transparency throughout the swap markets.
This rule, though perhaps not ideal in several respects, is undoubtedly improved from the uniform “social size” approach first proposed in the real-time reporting rule in 2010. Public comment has been essential in this regard. Many commenters raised concerns about the methodology for reaching the block-trading thresholds, the data set upon which the staff has applied that methodology, and definitional judgments that impact transaction distributions and therefore outcomes under the final rule. The Commission will need to keep a close eye on these matters once the rule becomes effective.
As the markets evolve and the Commission receives new data with which to analyze and set the block thresholds, the Commission has a responsibility to revisit our approach and consider whether this rule has in fact landed in the right place.
The final rule’s approach is admittedly blunt. But the Commission has attempted to balance as best it could potentially conflicting objectives.
As a final note, I have been especially concerned about supporting a competitive landscape for derivatives execution. Recent actions and comments by some have suggested that certain of the Commission’s rules unfairly or inappropriately favor futures execution. Again, the intent of these execution rules is not to do away with flexibility but rather to protect it.
What should be clear in the Commission’s rules is that participants will have clear choices—choices concerning margin treatment, modes of execution, clearing venues, and in some cases counterparties. If participants weigh carefully the available choices and choose a particular execution venue based upon their own economic interests, the Commission should not second-guess that decision and substitute its own. In the end, it is the participants, not the Commission and its staff, who will determine the types of risks that firms should retain or lay-off in the markets, and the means for doing so.
The Commission has strived to promulgate these rules in a manner that will avoid putting its thumb on the scale for any particular marketplace.
Thank you again to the staff for your hard work on the rules before us today. I look forward to discussing a few questions with you shortly.
Last Updated: May 16, 2013