SEF Certainty - Structured Credit Investor

By James Linacre


A perceived regulatory preference for CDS futures over swaps has caused serious consternation in the market. However, the publication of final SEF rules yesterday (16 May) has assuaged most concerns and paved the way for participants to advance.  

Bloomberg last month filed a lawsuit to prevent the US CFTC from implementing what it saw as flawed regulation (SCI 18 April). With rules for designated contract markets (DCMs) at that point far more advanced than those for SEFs, Javelin Capital Markets ceo James Cawley believes that Bloomberg certainly had a point.  

Legal uncertainty around SEFs and the drawn-out nature of the regulatory process actually caused trueEX to abandon early plans to register as a SEF as well, says its ceo Sunil Hirani. The firm intends to instead create futures contracts based upon S&P's new credit spread indices (SCI 11 April).  

A lack of action by regulators to bring clarity around SEF rules was seen to be creating an unfair competitive advantage for DCMs. With the CFTC's release of the SEF rules (see separate article), the mismatch in clarity between the rule sets has now been corrected, although other discrepancies remain.  

Another bone of contention has been the VaR difference between swaps and futures. "There is a mismatch on block sizes and there is a major mismatch on margin requirements, not least with one-day versus five-day VaR for IRS and credit indices," says Cawley.  

While there is a significant difference in the margin period for swaps and futures, Hirani believes that several factors account for this difference. He says it "should be based on the liquidity, risk, volatility and time for liquidation" but not on the wrapper. With tax, accounting and maintenance cost implications, he says it is more complicated than just one factor.  

However, Cawley says the shorter VaR for futures is very much because of predicted liquidity, predicated on the one factor of how quickly portfolios of futures and swaps are expected to be able to be liquidated. This would be more understandable if the swaps market was actually illiquid, but he suggests that there is a very liquid market for both credit indices and IRS.  

"This is based on the hypothetical liquidity of swap futures portfolios, which do not exist yet. It is based on a fiction. The IRS market is one of the most liquid and standardised in the world," says Cawley.  

While differences between the two products remain, the final rulemaking from the CFTC means that SEFs do now know where they stand as they compete with DCMs for business. Hirani says that ultimately providing choice to the market is the most important factor.  

"The world wants swaps and futures, so I think we should let the market decide. Our job is to provide the infrastructure which allows people to trade and that is what we are trying to do," he explains. He points to CME's deliverable swap futures (DSFs) as an innovative solution, which will help both the swaps and futures markets to grow.

The offering from trueEX will be a futures contract based off credit indices derived from the S&P 500. "That will be independently derived and based on debt outstanding, including a financials index component, and on the futures contract the names are going to be known," explains Hirani.  

He continues: "The vision is to take the trueEX futures contract on the S&P index and be able to offer it to every single person and institution in the world who trades S&P 500 equity futures. The goal is to exponentially expand the universe of investors who can express views on corporate spreads but does not currently have access to a transparent, regulated, standardised and independent futures contract."  

The new market agreed coupon (MAC) standard put forward by SIFMA and ISDA (SCI 24 April) is also a big step forward for the market, says Cawley. The argument against swaps has so far been that they are too bespoke and this goes a long way to negating such criticism.  

"As the market begins to trade on SEFs this summer, the time has come for a standardised coupon swap that trades with an IMM date. We expect to see liquidity take off in this new MAC product," Cawley observes.  

He concludes: "Now that SEF rules are finally here, thoughts that DCMs have first-mover advantage in the swaps market are unfounded. The fact is that the entire market is readying itself to trade transparent execution venues off the SEF mandate."  

This article was published in Structured Credit Investor on 17 May 2013.