CFTC Swap Guidance to Spur Bank Strategy Shift

By Dwight Cass

Open access to SEFs for dealers and end-users could accelerate banks’ move away from dealing. 

The Commodity Futures Trading Commission issued guidance in November that reiterated its demand that swap execution facilities (SEFs) allow all end users equal access to their market data and give them unimpeded ability to transact. Some of the 19 SEFs that had registered by the end of last month had given dealers an advantage over end-users in viewing bids and trading, something that runs afoul of Dodd-Frank. The CFTC’s focus on ensuring a level playing field could help to keep prices of cleared swaps competitive, perhaps enough so that the cost advantage lures even exempt corporates.

It would be prohibitively expensive and cumbersome for end users, whether exempt or not, to establish links to all the SEFs—there were 19 registered as of the end of November. But it makes sense for the 90 dealers that have registered with the CFTC to have those relationships.

Given their desire to avoid the capital cost of acting as dealers in bilateral transactions, the CFTC and market participants expect them instead to act as “aggregators”—that is, brokers, acting as agents for their clients, searching the SEFs for the best deals, and not as counterparties in the transactions themselves.

This is how stock and options markets work, with end users asking brokers to tap into the market liquidity of all the trading venues to find the best price on whatever instrument they want. This was a principal aim of Dodd-Frank, although reluctance among some SEFs to throw open their doors was keeping that goal from fruition.

Tongue Lashing

CFTC Chairman Gary Gensler discussed the issue in a speech on November 18:

Last week, CFTC staff issued guidance reminding SEFs of this core responsibility: the Commission’s regulations require SEFs to provide all its market participants—dealers and non-dealers alike—with the ability to fully interact on order books or request-for-quote (RFQ) systems.

SEFs are required to provide dealers and non-dealers alike the ability to view, place or respond to all indicative or firm bids and offers, as well as to place, receive, and respond to RFQs.

All market participants should feel confident that their bids or offers are being communicated to the rest of the market.

Further, SEFs must provide to all eligible contract participants (ECPs) market services, including quote screens and similar pricing data displays.

Mr. Gensler said the CFTC guidance answered questions from market participants regarding a number of hurdles that SEFs had implemented. For example, some had discriminatory requirements such as “enablement mechanisms” that blocked participants’ view of bids and offers. Others had required that end users enter into pre-execution agreements. Mr. Gensler said that SEFs that require participants to be dealers or clearing members were also breaking the rules. The specific requirements for SEFs are listed in §37.3—Requirements for Registration of the final rule: Core Principles and Other Requirements for Swap Execution Facilities.

“This does mean a paradigm shift from the business models of the past,” Mr. Gensler said.

“SEF registration was not meant to be just business as usual. Bringing access to the entire marketplace means platforms will no longer be just dealer to dealer or dealer to customer,” he added. “Through reform, all market participants who meet the standard of an eligible contract participant must be given impartial access.”

Paradigm Shift

This change in business models manifests itself at banks in a change from principal to agent in their derivatives business for clients. They will provide what is typically called “sponsored access” to the SEFs. The SEFs themselves seem to think that this is a big deal—GFI Group, the derivatives interdealer broker and SEF, thought it notable enough that Credit Suisse and UBS had signed up to use its SEF for rate swaps that it issued a press release trumpeting the new relationships.

The description of the relationship in the release sums up the new business model paradigm nicely: “Credit Suisse and UBS will act as agents, facilitating an easy transition for their customers as they comply with the Dodd-Frank Act and Commodity Futures Trading Commission’s (CFTC) SEF rules. UBS will also stream prices into RatesMatch Central Limit Order Book, adding additional liquidity to GFI’s market place for interest rates swaps.”

The International Swaps and Derivatives Association said last year that 20 percent of notional derivatives outstanding—$127 trillion at the time of their study—were not clearable. The CFTC has adopted this figure in its own pronouncements. These unclearable derivatives are, in underlying asset, size, maturity or some other characteristic just too unique for clearing, according to ISDA.

Nonetheless, bilateral transactions with corporate clients in which the bank acts as the principal will no longer be a core product. With some banks struggling to meet leverage and capital requirements, the additional regulatory capital these sorts of transactions require have caused some banks to crank up their prices and more will probably follow.

About 70 percent of new interest rate swaps are currently being cleared, and 99 percent of those are being cleared within 10 seconds of execution, according to the CFTC. Ninety three percent are cleared within 3 seconds. The CFTC’s campaign to pull down any obstacles that interfere with the market’s transparency and open access appears to be having some success.

Its consequences for exempt corporates’ bank relationships and their calculus regarding the cost of using standardized swaps versus sticking with bilateral swaps, will most likely be equally profound.