James Rundle: SEF Regulation: The Art of Compromise

I’ve heard perspectives about Dodd–Frank from every side of the debate. Title VII provisions that govern the move of standardized derivatives products from a bilateral, over-the-counter (OTC) model to a more electronic format have been among the most contentious. With the US Commodity Futures Trading Commission (CFTC) vote recently to pass rules on how swap execution facilities (SEFs) will operate, there’s finally been some progression that moves regulation in this area from theory to practice.

The reaction has been mixed. The Securities Industry and Financial Markets Association (Sifma) expressed disappointment with the final form of the rules, while others say they are satisfied with the trading procedures, allowances and provisions contained within the various measures passed. Ahead of the vote, rhetoric swirled around the idea that the CFTC might impose a minimum request-for-quote (RFQ) level of five per transaction. In the end, the regulators compromised, setting the minimum level at two, with an automatic increase to three after a year. An attempted amendment by Commissioner, Scott O’Malia, which would have forced the CFTC to consider data on instrument liquidity before the automatic increase, so as to gauge suitability, was rejected.

Clear Pictures
While some participants would have preferred no minimum RFQ level—and many have been right in pointing out that Dodd–Frank merely obligates SEFs to provide the ability to have RFQ functionality on an order book trading model, not that there have to be RFQ requirements—this was a compromise. The debate continues though, as regulators argue that the RFQ requirement will provide transparency and competition, while opponents say it does nothing for either. Transparency, says one interdealer broker, is already served by SEFs reporting trades to swap data repositories, not by revealing identities.

Reducing RFQ levels, though still controversial, is just one indication of offense and defense in the rulemaking process. Brokers in particular were concerned that their business models would take a battering by moving derivatives such as interest-rate swaps and non-deliverable forwards to a purely electronic basis. The CFTC, in a real victory for the industry, expressly allowed voice as a suitable execution method, with the associated reporting requirements.

Although O’Malia’s amendment was rejected, CFTC chair Gary Gensler pointed out that the CFTC is still obligated to review data on the effect of the regulation. In another perceived nod to the long time it’s taken to get to this stage, SEF registrants will be able to begin operations with preliminary approval, rather than having to wait for full licensing, provided they satisfy market surveillance capabilities and other criteria.

The SEF final rulings weren’t perfect, but that is the essence of compromise—each party sacrifices in order to gain.

Across the Pond
On the subject of regulatory harmonization, Gensler described SEFs and similar platforms, which are being formulated in Europe as organized trading facilities (OTFs), as essentially international in nature. The CFTC will look to Europe when the rules there are finalized, and align the SEF model with the chosen conventions and operational structures. This could mean no minimum RFQ requirements, should OTFs end up not being subject to them.

The SEF final rulings weren’t perfect, but that is the essence of compromise—each party sacrifices in order to gain. Given the cognizance of wider developments, and the surprising lack of myopia in the final rulemaking regarding long-term strategy, the upside is that this kind of policymaking could become more of a norm. Taking into account what happens elsewhere, and not just what’s contained within regional bubbles, is a thorny route, but an essential one in the world of electronic, globalized trading. The rules will sit in the Federal Register for 60 days, and general compliance is expected to kick in 60 days after that. With the political and legislative part of the race done, the technology drive now shifts into fifth gear.