By Peter Madigan
The start of the new regime for swap execution facilities (Sefs) was just days away as Risk went to press. But the two months leading up to it saw barely controlled panic, as electronic execution venues that didn’t think they would need to register as Sefs found out they would, clients and futures commission merchants (FCMs) were given reams of documentation they would need to read through and sign in a matter of weeks, and some overseas venues quietly asked US customers not to participate on their platforms in an attempt to avoid Sef registration.
Regulators are adamant the October 2 deadline will not be delayed, although Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC) has suggested targeted relief may be possible. Unless that is forthcoming, market participants will struggle to be ready, some claim. And that could leave clients shut off from Sef venues.
“We have been told by the incumbent dealer-to-client Sefs that they will be turning off functionality for non-Sef participants from October 2 if participants have not signed up by that date. To see liquidity in the book, you need to have signed and returned all the Sef forms, because they need to migrate all the liquidity to the Sef format by that effective date. If you don’t get the forms back by that date, then the flows to your desktop will go dark,” says a credit trader at a New York hedge fund.
It’s not just the clients that have struggled to get ready. The final Sef rules were published on May 16, and included a new footnote – footnote 88 – that essentially obliges all multiple-to-multiple platforms to register, even if they only offer products that aren’t subject to a trade execution requirement.
This prompted a sudden rush by trading venues that had previously thought they wouldn’t need to register until later – if at all – to complete their registrations in time. By September 26, 17 firms had filed Sef registrations with the CFTC, and 15 – BGC Partners, Bloomberg, GFI Group, Ice Swap Trade, INFX from Integral Development Corporation, Javelin Capital Markets, MarketAxess, State Street’s SwapEx, TeraExchange, 360 Trading Networks, Tradeweb’s DW Sef and TW Sef, Tradition, TrueEx and Tullett Prebon – had been temporarily approved.
More is required than filling in a registration form. Prospective Sefs would need to ensure connectivity with swap data repositories and clearing houses, adapt technology and workflows, and develop policies and procedures in line with the CFTC’s rules. All in all, the late addition of footnote 88 has posed a huge logistical challenge, venues say.
“Footnote 88 says if you are a multiple-to-multiple intermediary for any CFTC-regulated swap, then you have to register as a Sef. That has added many additional products alongside the rates and credit products that had originally been considered as subject to the execution mandate. The industry is working hard trying to get all the connectivity in place – to the clearing houses and swap data repositories – just for the four major currencies in rates and the credit default swap (CDS) indexes. But when the final rule came out and introduced interest rate options and credit default tranches into the execution mandate simply because these products are traded on a multiple-to-multiple venue, it made the process much more challenging,” says Chris Ferreri, managing director of hybrid trading at Icap.
Putting aside the time constraints, footnote 88 causes several other problems, participants say. For one thing, no products are currently mandated to trade on a Sef. In a speech at the International Swaps and Derivatives Association’s annual European conference in London on September 19, Gensler said the first mandatory trading requirements – for interest rates and CDS indexes – are likely to come into force in February 2014 at the earliest. Other products will follow later.
That means clients will face a choice: rush to sign Sef user agreements in order to trade electronically from October 2, or take advantage of the fact that none of these products are mandated to be executed on Sefs yet and turn to single-dealer platforms and voice broking instead. For some participants, all footnote 88 does is ensure a large number of Sefs will struggle to attract any liquidity at all from day one of the new regime. “Products such as foreign exchange swaps that are not required trades under the execution mandate will nonetheless be dragged into the fray, to the extent that clients will not be able to trade them on multi-dealer electronic platforms unless they sign Sef participation documents. Frankly, this is good for single-dealer platforms. But even the dealers that would benefit from this outcome are saying to the CFTC that these developments are not doing the market any good,” says the head of e-commerce at a New York-based dealer.
There’s another important implication. Market participants claim some non-US electronic trading platforms have asked US entities, including foreign branches of US banks, not to participate on their platforms, in an effort to avoid having to register as Sefs. This has had a knock-on effect on liquidity, with the market effectively split between US and non-US entities, participants claim (see box, An extraterritorial impact for Sef registration).
One of the biggest challenges, however, has been to get dealers and buy-side firms on board. Both have to sign and return user agreements before October 2, but both have found worrying clauses within the documents that have given them pause. For buy-side firms, it is the apparent need to sign execution agreements with any counterparty they transact with – a requirement some end-users say will effectively limit them to trading with the established dealers (see box, Sef execution agreement angers buy side).
For dealers, it is a clause that requires all trades to be guaranteed by a clearing member in order to achieve pre-trade clearing certainty. At first glance, this doesn’t appear too controversial. The CFTC requires each FCM to establish risk limits for its clients, and each has to use automated means to screen orders for compliance with those limits – known as regulation 1.73. The FCM then has to accept or reject the trades within a set time frame – currently 60 seconds.
The industry has worked to develop technological solutions to achieve this, including the development of credit hubs. But progress has been relatively slow, prompting some FCMs to connect directly to Sefs to either ping messages back and forth or push client credit limits to each trading venue (Risk September 2013, pages 38–39).
So long as the client trade falls within the limits set by the FCM, the likelihood is the trade will be accepted – ignoring the possibility of a technology glitch. But Sefs appear to be taking no chances. Keen to ensure clearing certainty, the rule books of most of the 17 Sefs to register include some requirement for a guarantee – and FCMs are not happy about it. “The whole thing is a mess. Many Sefs believe the limit checking requirements in regulation 1.73 require FCMs to guarantee clearing. This is plain wrong. Regulation 1.73 was designed by the CFTC to ensure FCMs maintain minimum standards of risk management. FCMs should not be the risk dumping ground as the industry transitions to electronic execution, and we believe this interpretation is fatally flawed,” says one dealer.
Some dealers even claim certain platforms have asked them to provide unconditional guarantees for their clients – a request they say is incomprehensible and irresponsible. “The Sefs spent a very long time arguing that the rules should be written quicker, but did not seem to use that time to figure out the clearing certainty issue. The ones that have been laziest are the Sefs now coming out with the most outrageous proposals and asking FCMs to provide blanket guarantees, which is nuts because no-one does that and no-one is going to blindly wave derivatives trades into clearing through its FCM – it’s just not going to happen,” says a New York-based head of clearing at a global bank.
Risk has seen rule books from all 17 Sefs to register, and the requirement for a clearing member to guarantee or accept financial responsibility for clearing client trades appears in 15 of them – although the language differs significantly. The Bloomberg BSef rule book, for example, states that “all trades in cleared swaps by a participant or its clients or customer must be guaranteed by a clearing member that assumes financial responsibility for such participant, client or customer”.
Another rule book – that of Tradeweb’s DW Sef – says “the Sef will not perform a pre-trade credit check on any swap transaction on the Sef and therefore, participants that are not direct clearing members shall have a clearing member guaranty their obligations with respect to each order and transaction effected on the Sef at all times the participant is active on the Sef”.
Some venues argue the guarantees neither stop the FCM from conducting pre-trade credit checks nor from rejecting trades that breach risk limits. Instead, they merely ensure FCMs do clear client trades that fall within those limits.
“FCMs have an important role to play here. Every platform has their own rulebook, but if the FCM set the credit limit for the client, theoretically it is appropriate that they agree to clear those transactions,” says Charley Cooper, head of exchange-traded derivatives trading and OTC clearing for the Americas at State Street, which has had its Sef platform SwapEx temporarily approved.
But other platforms go further. “Some market participants like to be in a disclosed environment and some anonymous. In an anonymous order book, you need to have the right kind of clearing arrangements in place because you need absolute certainty of credit to clear, since you don’t know the counterparty you are being matched with. As such, you need either to be a direct clearing member or have an FCM that is willing to stand for all trades without any pre-trade credit check, which would slow down the process in this fast matching engine,” says Lee Olesky, chief executive of Tradeweb in New York. The company has opted to register two Sefs: TW Sef, which includes both a central limit order book (Clob) and a request-for-quote (RFQ) system; and DW Sef, which offers an anonymous Clob without RFQ functionality.
Either way, dealers aren’t happy – and many are holding off signing participation agreements as a result. There are contrary views as to whether any dealers have signed up to Sefs. Seven of the platforms that spoke to Risk claim they have on-boarded at least some dealers and buy-side firms. Others acknowledge they have struggled. “If you ask the dealers how many Sefs they have on-boarded, I think you will end up hearing ‘none’ from quite a few of them. We haven’t on-boarded anyone as yet,” says one broker.
With days to go before the October 2 deadline, industry requests for a delay cranked up a gear. That may still happen, although most participants accept it probably won’t be delayed. But the end result may not be what regulators had in mind, participants warn.
“Was it the CFTC’s intention to take a market that was supported by a multitude of competing brokers and deliver it into the hands of the dealers? No, the intention of Dodd-Frank was to disintermediate the dealers, but on day one of the new regime, Gary Gensler’s determination to have the Sef regime up and running by October 2 will mean the new Sefs will have next to no clients and those that currently operate will largely have to shut down. The market is nowhere near ready for this all to come into effect,” says one interdealer broker.
Sef execution agreement requirement angers buy side
Buy-side firms are refusing to sign participation agreements with some newly registered US swap execution facilities (Sefs) because of a controversial requirement that commits end-users to negotiate bilateral trade breakage agreements with any counterparty they transact with on the trading venues, Risk has learned.
New Sefs, including New York-based TW Sef – an affiliate of Tradeweb – and at least one interdealer broker, are stipulating that end-users have execution agreements in place, which set out breakage terms and termination payments with counterparties in the event a trade is rejected by a clearing house.
Firms that don’t meet this requirement may not be able to trade on those platforms after October 2, when the new Sef regime comes into force.
Some participants have reacted angrily to the clauses, claiming it is not possible to negotiate execution agreements with large numbers of counterparties before the October 2 start-date – meaning buy-side firms will essentially be forced to transact with a handful of big dealers. “Euphemistically, the Sefs are calling this process enablement, as in ‘sign this agreement and you will be enabled to trade on our platform’. In reality, the process should be termed constraint,” says one buy-side trader.
“There is a long history of dealers trying to use bilateral counterparty credit risk as a wedge to keep the dealer-only paradigm in place. These agreements mean you can only trade on that Sef with counterparties you have execution agreements with, and, as a practical matter, you’re not going to negotiate these documents with all 100 participants on a Sef – you’re only going to do so with the large swap dealers,” he adds.
Buy-side firms have spent recent weeks examining the rule books published by those trading platforms that have applied to the US Commodity Futures Trading Commission (CFTC) for temporary registration as Sefs. The burden of working through them ahead of the October 2 deadline is proving a significant task in itself for buy-side firms – especially as some have only been published recently, following their approval by the CFTC. They complain the addition of restrictive execution agreements is compounding their documentation workload.
“The issue from our perspective is the volume of documents we need to now sign. While we are expecting to have signed agreements in place by the deadline, going through these rule books and working through agreements to be able to continue to trade products electronically is very frustrating. Some Sefs are requiring execution agreements and some are not, but without a clearing mandate – and many of the trades we are clearing now aren’t subject to a clearing mandate – it is not clear to me why I would need a cleared derivatives execution agreement, because if the trade breaks I’ll simply make it a bilateral trade,” says Michael O’Brien, head of global trading at Eaton Vance in New York.
The necessity of an execution agreement, formally termed a cleared derivatives execution agreement and developed jointly by the Futures Industry Association (FIA) and International Swaps and Derivatives Association, has also divided the Sef community. Some venues insist they are an important safeguard that provides legal certainty in the event of a trade rejection.
“These execution agreements are not stopping any participant from coming on to TW Sef to make markets to clients. In the event a trade does not clear, we need to have a fall-back position we can take to deal with any trades that may be rejected from clearing – which counterparty owns the trade in that situation? You need to have a process by which that eventuality is dealt with, and that’s why we need to have these agreements in place,” says Lee Olesky, chief executive of Tradeweb in New York.
However, others have a different view, arguing the agreements are unnecessary on Sef platforms. “We don’t accept the Isda-FIA agreements. These agreements say that if we send a trade for clearing and it fails, I can sue the original counterparty for the loss. The problem is, if your futures commission merchant is shutting you out of clearing, it’s not because you don’t have the money to pay for the trade today – it’s because you’re perceived to be a straw man that is going to be bankrupt tomorrow. All one of these agreements gives me is the right to sue an insolvent counterparty and to incur millions in legal costs in order to recover pennies on the dollar years from now. And these agreements have not even been tested. Why would a Sef want to get involved in these sorts of disputes?” says James Cawley, chief executive of Javelin Capital Markets in New York.