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SEC Chairman Speaks on Derivatives Market Reform Before STA Annual Meeting

In a speech ahead of the Security Traders Association (STA) annual meeting, SEC Chairman Mary Schapiro suggested the equity market structure could provide a good guide for reforming the OTC derivatives market. Below is the entire text of that speech, with the portions about OTC derivatives market regulation highlighted.

Speech by SEC Chairman: Remarks Before the Security Traders Association

By Mary Chairman Schapiro

Washington, D.C.

September 22, 2010

Thank you for inviting me to participate in STA's annual conference. It's an honor and a pleasure to speak to such a large group of trading professionals about the structure of our financial markets.

Market structure is a broad and important topic, encompassing everything from the number and types of venues that trade a financial product to the rules by which they operate.

A stable, fair, and efficient market structure lies at the heart of economic growth. It helps capital markets efficiently perform their essential function of turning investor savings into business capital. Effective market structure helps make possible an economy in which businesses grow and investors achieve their financial objectives.

As you know, the Commission is in the midst of a comprehensive review of the structure of our equity markets — a review which began a year ago. In addition, market structure is an important element of the Commission's new responsibilities for OTC derivatives under the Dodd-Frank Act.

Today, I would like to discuss market structure challenges that may be making the equity markets less efficient, and how these challenges might be addressed. And I would also like to spend a moment on how we can apply the lessons we have learned in existing markets to the derivatives markets that will soon come under comprehensive regulation.

To see the full text of Chairman Schapiro's Speech, visit the SEC website.

Visit our regulation resource center to learn more about OTC derivatives regulation reform in the U.S., UK and Europe.

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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. 


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. 


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 21st 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.

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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.

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Committee Releases Conference Report

The House Financial Services Committee has released the final version of the Conference Report, which melds the two financial regulation reform bills passed by the House of Representatives and by the Senate. Read the full text of the report here.

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House Offers Amendment to Swap Execution Facility Definition

All eyes are on Washington today, as the Congressional conference committee begins its public debate to meld the Senate and the House version of the financial reform bill. One of things the committee members will be considering is an offer from the House of Representatives to amend the derivatives portion of the Senate legislation.  

Among a myriad of things, the House's offer alters the definition of swap execution facility (SEF). The House uses the term "voice brokerage facility" in its definition of SEF, which could potentially widen the range of what can be considered a swap execution facility to include trading done via a telephone. Although the creation of swap execution facilities would serve to promote electronic trading in OTC derivatives markets, including the voice brokerage in the definition could cause potential problems and confusion. For example, including "voice brokerage" in the definition of SEF could potentially lump technically unsophisticated facilities with the fully electronic trading and execution platforms. While most swaps are currently traded via phone, electronic trading is already on the rise as market participants take advantage of the benefits of electronic trading, such as greater efficiency and transparency.   

The proliferation of SEFs in the derivatives market would create healthy competition among execution venues - just like ECNs or ATSs did for the equities trading space. It remains to be seen how much of the House's offer the Senate allows through into the final version of the bill.

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Conference Committee Begins Public Debate

The 43-member Congressional conference committee will begin its public debates today on the Restoring American Financial Stability Act of 2010, which contains 12 major sections and spans almost 2,000 pages. The conferees are expected to consider an offer made by the House to amend the Senate's version of the legislation, specifically focusing on the mandate that would require banks to spin off their swaps operations. The committee hopes to have a bill approved by both chambers of Congress and signed into law by President Obama by July 4.

You can watch the debates live here.

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Sen. Lincoln’s Clarifications Cloud OTC Derivatives Market

As the Congressional conference committee continues to reconcile the Senate's and the House's versions of the financial regulatory overhaul bill, it is becoming possible that some version of the so-called Lincoln Amendment might survive to the end.

Earlier this week Sen. Blanche Lincoln introduced some clarifications to her mandate in the proposed bill that would require banks receiving federal financial aid to spin off their swaps desks. Lincoln's proposed changes would allow umbrella bank holding companies to own swaps dealers, but only if they are separated from their traditional banking arms. In addition, Lincoln's new proposal would give banks up to two years to spin off their OTC derivatives business lines and exempts companies that aren't major dealers in derivatives from the new rules.

Many see Lincoln's proposed clarifications as a weakening of the amendment, which might be enough to keep it in the final bill that Congress hopes to have ready for President Obama to sign by July 4. Even though it's now slightly less harsh, the fact that the Lincoln Amendment still remains in the proposed bill could hurt the OTC derivatives industry. Requiring banks to separate their derivatives businesses is an unnecessary step that could cause more harm than good, creating market inefficiency and adding needless operational costs.

The Lincoln Amendment, which was brought to the conference committee from the Senate's version of the bill, is one of the biggest contention points in the current ongoing debate. As the committee meetings continue in the coming days and weeks, members will be making crucial regulatory decisions that will greatly affect the OTC derivatives market. Increasing transparency in the marketplace will promote stronger risk management, create more efficiency and drive more participants into the space.

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Conference Committee Resumes Meetings

The 43-member Congressional conference committee will resume its debate today at 11:00am EST on the Restoring American Financial Stability Act of 2010, which contains 12 major sections and spans almost 2,000 pages. The conferees are expected to address issues on federal banking regulation, hedge funds, credit-rating agencies and insurance issues in today's talks. The committee hopes to have a bill approved by both chambers of Congress and signed into law by President Obama by July 4.

You can watch the debates live here.

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Conference Committee Begins Debates

The Congressional conference committee begins its open-forum debates today. Members from the Senate and the House of Representatives will work to meld the two financial regulation bills into one joint piece of legislation, which they hope to have signed into law by President Obama by July 4. One of the main points of contention is the Lincoln Amendment, which would require banks to spin off their OTC derivatives operations.

You can watch the live debates here.

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Q&A: Stephen Bruel, TowerGroup – Technology and OTC Derivatives Reform

Stephen Bruel, Research Director, Securities & Investments at TowerGroup, talks to about the role technology will play in the pending financial regulatory reform and what the buy-side can expect.

Q: What are some challenges with processing OTC derivatives that firms face today?

A: There are strategic challenges that center on complying with changes in the regulatory structure, such as the advent of central clearing. There are also tactical challenges around post trade processes, especially valuations and collateral management. As a matter of fact, in a recent TowerGroup survey, we found that 71% of respondents felt they needed to improve their valuations process and 58% needed to improve collateral management.

Q: How will the pending financial regulation affect OTC derivative processing?

A: We won't know exactly how pending regulation will affect OTC derivatives processing until the final legislation is passed in the US and abroad. Two key areas to watch are clearing and global harmonization (or lack thereof). On the clearing side, there will be significant operational and technology changes required. From a global perspective, the US legislative process is receiving a lot of attention, but other markets, especially Europe and China, are developing their own frameworks, as well.

Q: What are some main concerns firms are currently faced with when it comes to OTC derivatives and regulation?

A: Overall, the concern in the industry remains the lack of finality on the details. As we get closer to a final legislative product, financial services institutions will be able to execute against whatever the requirements are, but until that time, there are open questions and delayed investments. In addition, there is a concern that the regulation will hinder the ability of firms to hedge risk, as well as limit the profitability of derivatives dealing. 

Q: How will central clearing affect the industry?

A: Central clearing will change the economics of trading OTC derivatives and require changes to technology and operations. There will be benefits - for example, the buy-side can reduce counterparty risk. This partial removal of the counterparty risk concern may also attract new users of OTC derivatives, increasing volumes in the industry. In addition, CCPs can become more responsive to buy-side needs to attract new users.  CCPs understand that though the buy-side is in general supportive of clearing, they also need products that support their business needs. For example, many on the buy-side hope to net margin requirements across asset classes, which they can do today with their dealer counterparties. As of now, CCPs are not ready to provide cross asset class margining, limiting buy-side adoption of clearing.

Q: What are some of the positives and negatives of the pending OTC derivatives regulation?

A: Rarely is there a piece of legislation that creates benefit without inflicting any harm on an entity. The OTC derivatives legislation is no exception. Because the final details have not been agreed upon, we can instead look at the main regulatory goals: transparency and standardization. Transparency is great, if it means improved price discovery and an easier way to evaluate a counterparty. It is not as beneficial if it means revealing complex trading strategies. Standardization is good when it allows investors to hedge their risks in a more efficient (and less expensive) manner. Standardization however can be a detriment to risk management if hedgers with unique risks are unable to properly hedge that risk because no standardized product meets the goal.

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