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Work to Hammer out OTC Derivatives Rules Begins

Now the work really begins. After President Obama signed the Restoring American Financial Stability Act of 2010 into law, the financial industry regulatory bodies must now develop the rules, which will have a major affect on the OTC derivatives market.

Over the coming months, the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC) will write a new regulatory framework designed to reduce systemic risk and establish more rigorous oversight of these essential risk management instruments to better serve market participants. These changes will include requirements for trading swaps on regulated platforms, central clearing of transactions and mandatory trade reporting.

While this bill has historic implications for trading in the OTC derivatives market, it remains unclear how these changes will be implemented. However, overall, the industry stands to benefit from the pending mandates. The new regulatory environment will drive the majority of swaps trading onto regulated Swap Execution Facilities (SEFs), or exchanges, which will preserve an OTC marketplace for derivatives, providing clients with access to liquidity providers in an efficient manner that complies with the new regulation.

Even though the new rules have not been hammered out yet, the passing of the Restoring American Financial Stability Act of 2010 is a move in the right direction for the OTC derivatives market.

SEF 101: Deconstructing the Swap Execution Facility

By Kevin McPartland, Senior Analyst at TABB Group

The term “Swap Execution Facility” (SEF) has been formally christened and will henceforth be a part of OTC derivatives vernacular. Yet to be determined, however, is whether SEF will become merely a new label for existing businesses or conversely an open door for competition, innovation and transparency in OTC derivatives price discovery and execution.

The Dodd-Frank financial reform bill lays the foundation defining an SEF to be “a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce.”

If the word “swaps” was replaced with “goods” this could be a description of eBay. The vague definition was not accidental, however. Congress quickly realized that trying to legislate execution methods (fully electronic, hybrid, etc.) and price discovery mechanics (continuous two-sided quotes vs. request for quote (RFQ)) is highly contentious and more importantly not critical to the stated goal of reducing systemic risk.  How exactly trades are done is of minimal consequence as long as trades are reported in a timely manner (more on what “timely” means shortly). As I have discussed in several previous research notes, electronification of this market does not need mandating – it will come about organically under new rules.  SEFs therefore must be defined in such a way that they provide regulators with oversight of standard swap executions to ensure a fair and orderly market.

It is also important to note that SEFs are not exchanges. If they were exchanges, Congress would not have made the designation between SEFs and boards of trade (BOT). BOTs are registered exchanges that can define contract terms, “liquidate or transfer open positions,” “require market participants in any contract to meet special margin requirements” and are required to comply with numerous other regulations. The SEF to BOT comparison is similar to the alternative trading system (ATS) to exchange comparison in the equities world. SEFs and ATSes are simply mechanisms for linking buyers and sellers, whereas exchanges have much broader mandates.

As we move into the rule writing process regulators do not have the Congressional luxury of being vague. They must define with excruciating detail what an SEF is and is not. Those details will include registration and ownership requirements, a list of what products must trade via an SEF, as well as how SEFs can and must gain access to clearinghouses. All will have a huge impact on how this market develops and whether innovation and competitive forces will overtake the status quo.

Registration & Ownership 

The regulators have considerable latitude in determining how onerous (or not) the process will be for becoming a SEF. The Dodd-Frank language states that hopefully SEFs must meet “any requirement that the Commission may impose by rule or regulation.” This is arguably vaguer than the definition of SEF as discussed above. The final requirements here are critical; however, as a filing process that is too complex would raise barriers to entry potentially eliminating innovative, would-be SEF startups and in doing so favor big established players.

The next variable in that equation is ownership limits. The Lynch Amendment, which as part of the House Bill passed in December 2009, was set to limit dealer ownership of both execution facilities and clearinghouses. The amendment did not become part of the final Dodd-Frank bill; however, the bill does state that regulators “shall adopt rules which may include numerical limits on the control of, or the voting rights with respect to, any derivatives clearing organization that clears swaps, or swap execution facility or board of trade designated as a contract market that posts swaps or makes swaps available for trading.”  That means the spirit of the Lynch Amendment is still alive and well.

“Numerical limits” would be bad for banks (“with total consolidated assets of $50 billion or more”) and for the clearinghouses with considerable bank ownership: LCH.Clearnet and ICE Trust, for example.  Although it remains highly improbable that anyone will be asked to divest their stake in an existing relationship, changes in the existing capital structure would likely trigger the new rules and upstart execution, or clearing venues might find it tough to find both funding and backing as both have historical come from the large dealers. 

For those already in or looking to enter the OTC derivative execution business, limiting bank ownership could be huge. If the major dealers (who are the major sources of liquidity) cannot create their own SEFs then their trade volume will have nowhere else to go but through an independent SEF. Furthermore, with the behemoths of OTC derivatives locked out of the SEF picture the inter-dealer brokers and independent platforms will be large and in charge. Those winners may very well still be decided based on the chosen few those same major dealers decide to trade with; however, with limited ownership in any one platform liquidity would likely be much more transient based on fees and technology. 

Products 

The next question is what will trade via SEFs. Again to the regulators – whatever they determine must be cleared must also be traded through an SEF (or Board of Trade, but I’m going to ignore that part for now). So we can easily assume index CDS contracts, vanilla interest rate swaps (2yr, 5yr, 7yr, etc.) and potentially some FX swaps will begin trading via SEFs. TABB Group estimates show that up to 80% of interest rate swaps could be deemed standard in the next several years, ensuring their movement onto SEFs, for example. 

Per the above, this does not mean execution will become immediately all electronic for these products, it only tells us that trades will be processed by registered SEFs and ultimately be reported to regulators.  For dealer-to-dealer trading this will not be a huge change, as most of that flow already goes through interdealer brokers soon to be partially rebranded as SEFs. According to DTCC data, 83% of CDS transactions are D2D and 99.99% of transactions have a dealer on at least one side of the trade. For Dealer to Client (D2C) flow where trading is often done without an intermediary, these new rules could be a boon for existing platforms such as Bloomberg or Tradeweb and new entrants looking to facilitate client flow.

Clearing Access

Products that must be cleared are one in the same with those that must trade via an SEF; therefore SEFs must have access to a clearinghouse. This is stated in the definition of clearinghouse which requires OTC derivative clearinghouses to “provide for non-discriminatory clearing of a swap … executed bilaterally or on or through the rules of an unaffiliated designated contract market or swap execution facility.” This means that, for example, ICE Trust must accept trades on a non-discriminatory basis executed at ICAP (as long as one of the trade counterparties is a clearing member at ICE, of course) even though ICE-owned CreditEx is a direct ICAP competitor.

It is unclear, though, where the line between competitive practices and discriminatory access will be drawn. Vertically aligned firms, those that provide both execution and clearing services for OTC derivatives, will look for ways to incent market participants to both execute and clear with them. For example, they could price services in such a way that huge cost savings would be had if a trade was both executed and cleared via their platforms – clear with us and the execution is free!  It is also possible the vertical firms could limit direct electronic access to all but their own SEF, forcing outside SEFs to send trade details manually rather than via a more automated method. I’m speculating of course, but just saying clearinghouses must let all SEFs in only scratches the surface in creating an open and competitive execution landscape. 

Reporting 

Last but not least is reporting. As stated above it’s not the method of execution that makes the SEF designation important, but the fact that trades will be reported to regulators and over time to the broader market. The legislation states that “data relating to a swap transaction, including price and volume” must be reported in real time. Wow – from limited transparency to real-time reporting? Maybe. The legislation goes on to define real time to be “as soon as technologically practicable after the time at which the swap transaction has been executed.”

The “technologically practicable” label is pretty straightforward in my eyes. Trades should be reported within milliseconds of completion, as technology clearly makes that feasible. However, the question here is not about technology, but about when the trade is considered done. OTC derivative markets don’t operate like equity markets where executions are finite and fast. Hitting an offer to sell 100 shares creates a completed order of 100 shares. For many OTC derivative transactions, accepting an initial offer to sell a $50 million IR swap does not necessarily mean the trade is over. Further negotiating can go on between the counterparties to increase the trade size, negotiate affiliated hedge pricing or notional amounts. Only after this process completes and the trade details affirmed can the trade be considered done. 

The CFTC should not focus on “technologically practicable” but instead better define “the time at which the swap transaction has been executed.” 

Moving Forward 

Although competition of independent execution facilities has proven over time to decrease execution costs dramatically (OTC execution fees are much lower that typical exchange-traded fees), too much competition between clearinghouses can decrease their effectiveness. The benefits of cross-margining and capital efficiencies that clearinghouses can provide become diluted as more clearinghouses are introduced. A dozen clearinghouses are not good for the market.

New venues are already being born such as the recently announced Eris and Javelin platforms while existing players such as BGC, GFI, ICAP, Tradeweb and others are have begun their assault on the new world.  Whoever manages to win this new fight for liquidity, the birth of the SEF will finally bring OTC derivatives into the 21^st century, driving them to utilize the technological and market structure innovations seen over the past two decades while not killing the benefits of the OTC model.  Exactly how earth shattering these changes will be largely comes down to the regulatory rule writing that is about to begin.

President Obama Signs Financial Reform Bill Into Law

President Barack Obama is set to sign the Restoring American Financial Stability Act of 2010 into law today. Watch live.

Q&A: OTC Derivatives Operations and the Pending Regulation

Jeff Zoller, Executive Sponsor of the Derivatives Working Group at ISITC (International Securities Association for Institutional Trade Communication), talks to DerivAlert about how the pending OTC derivatives regulation would affect operations and processing. 

Q: How will the pending regulation affect the back-office operations and processing of OTC derivatives?

A: Two key provisions of the recently passed legislation require (1) central clearing and (2) data collection and publication through clearinghouses or swap repositories. The industry had already begun working toward these objectives through the commitments outlined in the letters to the New York Fed and other regulators, so in a sense, we "saw it coming" and have been preparing for these requirements. However, much of the detail has yet to be defined – for example, how will "major swap participants" be defined; at what point in the trade will transparency via the clearinghouse or repository be required (e.g., time of execution v. end of day); will there be margining requirements for OTC derivatives that do not clear, etc.

Q: Does the industry need to invest in new technology for their OTC derivatives processing, collateral management, etc.?

A: Yes – in short, the industry will need to be prepared to trade electronically, clear centrally and report to a trade repository. The interfaces, infrastructure and operational processes to support these requirements need to be developed. In many cases, this will require new systems or modifications to existing systems. Additionally, modifications to order management systems may also be required to handle OTC derivatives. It is important to note that many firms have already begun this process.

Q: What concerns are you hearing from your members at the ISITC Derivatives Working Group?

A: The participants in the ISITC working group have been focused primarily on issues regarding the current central clearing participants' models for supporting buy-side trading and, more specifically, some of the issues faced by 40 Act funds with respect to the movement of collateral. Since most of the high level requirements in the legislation were expected, it has been a bit of a "wait and see" approach. The next few months will be quite busy in sifting through the details and in making sure firms understand the requirements.

Q: What will the industry need to do to be ready for the pending regulations?

A: The industry must monitor and proactively respond to the new regulatory requirements. It is important that firms do not underestimate the effort that will be required to select and onboard derivatives clearing agents and the CCPs. First, as there may not be one CCP that spans all instrument types, multiple CCPs may be required. Second, the sell-side is wary of a rush to get onboard as the implementation date approaches – a prospect that could prove logistically challenging. The Derivatives Working Group provides a valuable forum to discuss these details and talk with peer firms about how they are preparing.

Q: Are the pending mandates shifting the focus to OTC derivatives processing or has that always been one of the main concerns for the industry?

A: Automation of OTC derivatives has been a key priority for a number of years. The industry has worked well together to develop solutions to facilitate automation, define achievable targets and commit to such targets via the letters to the NY Fed and other regulators. Messaging capabilities and standards have also evolved quite a bit, with the Working Group taking a lead role in defining such standards. I don't believe that there were too many surprises in the legislation.

Q: What benefits and challenges can the industry expect from the pending OTC derivatives regulations?

A: One of the key benefits of central clearing is portability – in the event of default, positions and collateral will be transferred to other counterparties. While it is expected that a central clearing model will reduce the operational workload with respect to collateral management, it is somewhat expected that the overall transaction costs for OTC derivatives will increase. The key challenges are in the implementation of this model – how much will exchange-traded, centrally cleared OTC derivatives look and feel like listed futures; can positions be traded across CCPs; what is the overall impact to non-cleared OTC derivatives, etc.

Q: What are your main goals at the ISITC Derivatives Working Group at the moment?

A: The ISITC Derivatives Working Group will be focused on understanding the key provisions of the recently passed legislation and the impact to our members. Accordingly, we will continue to invite industry experts to our Working Group meetings to help address our members' concerns and questions. ISITC continues to work with other industry groups to address the current issues associated with central clearing for the buy-side, and we'll continue our work on messaging standards, extending our best practice recommendations to additional instrument types.

Industry Leaders Comment on OTC Derivatives Regulation at the SIFMA Regulatory Reform Summit

Yesterday, as U.S. Senators prepared to cast their final vote on the Restoring American Financial Stability Act of 2010, industry members gathered to discuss what the pending regulatory changes will mean to the OTC derivatives market at the Regulatory Reform Summit held at the Marriott Marquis in New York City, hosted by the Securities Industry and Financial Markets Association (SIFMA).

Speakers including Robert Cook, Director of the Division of Trading and Markets of the U.S. Securities and Exchange Commission (SEC); Gary Gensler, Chairman of the U.S. Commodity Futures Trading Commission (CFTC); and Neal Wolin,Deputy Secretary of theU.S. Department of the Treasury, talked about the day’s Senate vote and how the new regulation will affect the industry.

Gensler, who spoke in the morning, said, “The bill requires strong regulation of over-the-counter derivatives dealers for the first time. This includes both bank dealers on Wall Street and nonbank dealers, such as the next AIG. Dealers will be subject to capital and margin requirements for their derivatives books to lower risk. …This will promote market integrity by protecting against fraud, manipulation and other abuses. Business conduct standards also lower risk through uniform back office standards for netting, processing and documentation. Dealers will for the first time be required to meet recordkeeping and reporting requirements so that regulators can police the markets.” 

Read Genler’s complete comments from the SIFMA Regulatory Reform Summit here.

Wolin, who spoke after the results came back from the Senate’s cloture vote, said, “First, this bill makes it possible to identify and manage systemic risk in a way that we could not do before. … This legislation gives us the tools, for the first time, to look beyond the safety of individual firms or markets to the health of the broader financial system.  Second, this legislation requires that regulators impose substantially stronger prudential standards. Robust, risk-based capital, leverage, and liquidity standards will provide a more reliable buffer against both firm-specific failures and systemic shocks.  And prudential requirements will be higher for the largest, most interconnected firms – requiring them to internalize the risks they impose on the system by virtue of their size and complexity.”

Read Wolin’s complete comments from the SIFMA Regulatory Reform Summit here.

Tradeweb Statement on Derivatives Reform

Lee Olesky, Chief Executive of Tradeweb, issued the following statement after the passing of the Financial Reform Bill:

Tradeweb supports the passing of today’s historic financial reform legislation. We believe that this new regulatory framework will drive the majority of over-the-counter derivatives trading to electronic platforms. However, history teaches us that the inevitable compromises made in the legislative process can lead to ambiguities as reforms are implemented. 

It is essential that the resulting regulations effectively expand the framework for a more transparent and competitive marketplace, such as trading through swap execution facilities (SEFs). These new rules must clearly define a setting for the trading of OTC derivatives that better serves market participants, enhances transparency, reduces systemic risk and enables more rigorous oversight of these important risk-management tools – the same principles that have driven the growth of electronic trading for the OTC markets over the last 10 years.

Senate Moves the Financial Reform Bill Forward

In a 60 to 38 vote, the Senate moved to end its debate on the pending financial regulatory bill. The final vote on the pending legislation is expected at 2pm EST today.

Watch the Senate proceedings live.

Senate to Vote on Financial Regulation Bill Today

The Senate is expected to vote this morning on the Conference Report, which the House of Representatives approved in a 237 to 192 vote last month. The bill needs at least 60 votes to pass, at which point the legislation will be ready for President Obama to sign into law as early as next week.

Watch the proceedings from the Senate floor live.

Senate to Vote on Pending OTC Derivatives Bill Thursday

The Senate scheduled its final vote for the pending financial regulatory overhaul bill for Thursday morning, July 15, 2010. The bill needs at least 60 votes to pass, at which point the legislation will be ready for President Obama to sign into law. Congress members had hoped for passage before July 4, but met with some delays. The House passed the bill last month in a 237 to 192 vote.

Combined Bill to Bring Transparency to OTC Derivatives Market

Late last week, the House of Representatives approved the bill hammered out by the Congressional conference committee in a 237 to 192 vote. The committee wanted to have the legislation, which combines bills passed by the House and the Senate, to President Obama to sign into law by July 4. However, with Sen. Robert Byrd’s passing, the Senate decided to postpone its voting session until after the July 4 holiday recess.

The proposed legislation from the Senate and the House will bring greater transparency and efficiency to the OTC derivatives industry. One of the mandates in the pending bill would require standardized derivatives to be traded via swap execution facilities (SEFs) or exchanges and be routed through clearinghouses. This, along with the requirement that customized swaps be reported to central repositories, would bring OTC derivatives trades into the open, lowering risk and adding efficiency to the market.

The Senate is set to vote on the proposed legislation after Congress reconvenes on Monday, July 12. Although the vast bill contains provisions that will affect almost every aspect of the financial landscape, the OTC derivatives provision have been a main point of contention during the preceding Congressional debates.