CFTC Offers New Proposal on Swaps Trading

By Katy Burne


Federal regulators seeking to rein in the opaque $583 trillion market for privately negotiated derivatives passed a set of proposed rules for how the majority of swaps would have to be executed once the Dodd-Frank financial overhaul law goes into effect next year.

The Commodity Futures Trading Commission rules give swaps users more flexibility over how and where they trade, and creates more competition among derivatives-trading venues.

They were revised from an original proposal that was scheduled to be voted on Dec. 9, but was delayed to allow time for fine tuning. The new proposal was passed by CFTC commissioners in a 4-to-1 vote, and will now be published for public comment. A second vote is needed for it to be implemented.

The derivatives industry has been scrambling to understand how the new rules would work because there are hundreds of millions of dollars in profits to be made from trading platforms that are approved by regulators under the new regime.

At issue is what business models the CFTC will allow for so-called swap-execution facilities, or SEFs, a catch-all term for new swap-trading platform brought about by the Dodd-Frank law that will be an alternative to trading swaps on exchanges.

In an interview with Dow Jones Newswires on Dec. 9, CFTC Commissioner Jill Sommers said the first iteration of the SEF proposal was too narrow in scope. "The Commodity Exchange Act defines a trading facility, but the new statute contemplates that SEFs could also be traded on systems or platforms, not just facilities," she said. "By introducing these new undefined terms into this act, specifically regarding SEFs, it meant we should be looking at a broader model for executing swaps on SEFs than what exists in the futures world today," she said.

The compromise version that passed imposed fewer restrictions on users of swaps. "We've come a long way from last week," said CFTC Commissioner Scott O'Malia at a hearing. Ms. Sommers was the only commissioner who voted against it.

Dodd-Frank will force standardized over-the-counter derivatives to be traded on exchanges or SEFs, and to be guaranteed by clearinghouses, similar to how futures contracts are traded. How large, market-moving trades called 'block trades' will have to be executed is expected to be addressed in a CFTC hearing Thursday.

A key feature that was removed from the revised SEF rule proposal was an earlier requirement to trade certain swaps exhibiting "material transaction volume"--as determined by historical swap-trading data--via open systems such as exchanges. That would have meant standardized swaps trading more than 10 times a day would have had to be traded on platforms using so-called central limit order-book technology, where executable bids and offers are immediately transmitted to a screen for all to see.

SEFs are different because they would achieve price transparency by aggregating dealer-to-customer or dealer-to-dealer execution prices.

The CFTC's proposal is to allow standardized swaps to be traded anonymously either exchange-style, using CLOB systems, or on one of two kinds of SEFs involving so-called request-for-quote technology.

Eligible request-for-quote systems would allow swap buyers to ask for prices and receive them in return from one dealer on a single screen, or to receive regular, live prices both indicative and executable on one screen from no fewer than five dealers at a time.

That would give swap buyers the flexibility to trade the way they want, and it would mean customers would see a stream of prices even if they didn't request a specific quote from a dealer.

Some trading platforms planning to register as SEFs already have the capability to provide both forms of request-for-quote trade execution. Online bond and fixed-income derivatives marketplace Tradeweb is one such facility. Likely future SEFs also include Bloomberg and MarketAxess.

One of the CLOB systems planning to register as a SEF for credit and interest-rate derivatives is Javelin Capital Markets.

"Be it RFQ or CLOB, the CFTC has now spoken," said Jamie Cawley, Chief Executive Officer of Javelin. "OTC derivatives must now come into the light and be traded on transparent electronic platforms."

Lee Olesky, CEO of Tradeweb, said "Combined with the clearing mandate, this move to electronic trading will ultimately lead to reduced systemic risk in the derivatives market."

Hybrid platforms would also be allowed, meaning trades could be executed by phone and the trade details be entered on a trading screen for price transparency.

The International Swaps and Derivatives Association, a swaps trade body, has argued that the OTC derivatives market already has sufficient transparency. "A very large majority of users ask multiple dealers for price quotations and believe they get competitive pricing," said ISDA in a statement earlier this week. "They are not clamoring for additional transparency."