SEF Operations Rules Delayed, Again

For anyone who attended the TabbForum’s Fixed Income 2013 and heard CFTC Commissioner Scott O’Malia suggest that the industry may see the vote happen as early has mid-February, the news is a disappointment. At least there’s a bit of a silver lining in the news for us regulatory, market-structure and technology nerds – we will not ruin our Valentine’s Day by waiting for the voting results.

According to a report published by The Wall Street Journal yesterday, US Commodity Futures Trading Commission (CFTC) officials decided to move back the regulator’s vote on the operation rules for swaps execution facilities (SEFs) to March 1. Although that date is not carved in stone.

Whenever the CFTC releases the rules, whether in two weeks or two months, it will be a serious cluster… quilting bee.

I’m not saying this because I doubt the CFTC’s competence: The CFTC commissioners and staff are among the hardest working people in the industry. It is about delivering prescriptive rules for a brand new market structure that incorporates at least six electronic-trading models (request for quote last look, request for quote firm, request for stream, continuous stream, scheduled auction and central limit order book) as well as support for voice trading.

Most of the financial markets of which I can think grew up organically. The regulators did not come on to the scene until these markets had major issues, which required tighter regulation and oversight.

Now, however, dealers and their clients will enter this environment from a standing start. Not only will they have the challenge of learning the “rules of the road” while searching for liquidity across about 20 planned SEFs, they will need to deal with a rapidly changing landscape as the SEF market consolidates to a handful of facilities that can attract enough liquidity to stay viable.

It’s like being stuck in a car with a student driver who is trying to master the use of the clutch for the first time while stuck in bumper-to-bumper construction on an expressway. The only difference is that you’re putting millions of dollars at risk and not a few thousand for a new clutch and transmission.

The SEFs are the bastard children of the designated contract markets (DCMs) and over-the-counter (OTC) trading markets. Nobody wanted them, but everyone has to deal with them thanks to the OTC markets playing it fast and loose for several crazy years.

In all likelihood they will exist as a bridging mechanism trading a limited set of instruments as they pass from being OTC contracts to swaps-based futures trading on DCMs.

There’s been a lot of industry discussion about creating a level playing field between swaps and swaps-based derivatives trading since the instruments are “economically equivalent.” They might be highly similar, but they are not equivalent. Just consider the respective processes when on party cannot honor their trade obligation.

Also, should there be a level playing field between SEFs and DCMs?

Congressional intention of the Dodd-Frank Wall Street Reform and Consumer Protection Act was not to create a new financial market just for the thrill of it. It was to move a large amount of risk out of an opaque market to a transparent one.

The process has already begun in the interest-rate swap (IRS) market as the CME Group and Eris Exchange launched their IRS-based futures products at the end of 2012. As investors become more comfortable with these new instruments, DCMs will launch other offerings to meet client demand.

Yet, “swaps futurization” is not the only liquidity issues facing SEFs. There is not one single dealer that wants to see its high-margin OTC products trading on a SEF. This is why there is such a push to have the CFTC decide which contracts should be made available to trade on SEFs rather than the SEFs themselves. The regulators would take more time deliberating which contracts to select than an individual SEF operator looking to boost its trading volume, thus protecting a dealer’s OTC margin a little longer.

Eventually there will be two types of liquidity available on SEFs – the transient liquid instruments that DCMs will turn into futures contracts once and those less liquid products that have enough demand to warrant electronic trading but not enough to warrant similar futures contracts.

How long will it take for the swaps market to reach this expected level of equilibrium?

If I knew that, I would shut down this blog and live off an obscene amount of wealth some place where they have no word for snow.