Saturday, April 09, 2011

Exclusionary Discretion in SEC Proposed Swap Execution Facilities Concerns Hedge Fund Industry

The hedge fund industry is troubled by the discretion the SEC would give a security-based swap execution facility to preclude access to its platform to any eligible contract participant that is not registered with the Commission as a security-based swap dealer, major security-based swap participant or broker. In a letter to the SEC, the Managed Funds Association said that giving swap execution facilities such discretion could prejudice many market participants that should be eligible to participate in the trading of security-based swaps, such as hedge funds that are not so registered.

The MFA urged the SEC, in finalizing this part of its Dodd-Frank rulemaking, to allow all eligible contract participants to become participants in a swap execution facility. The MFA also noted that, since registered investment adviser will be subject to SEC oversight, the Commission should permit them to become swap execution facility participants. In order to ensure the impartial application of the swap execution facility’s admission requirements, the MFA asked the SEC to require the independent directors of the swap execution facility to review all applications from potential participants.

The proposal would require swap execution facilities to set and enforce rules governing the manner in which they will handle block trades.The MFA is concerned that subjecting block trades to the same pre-trade transparency and order interaction requirements as non-block trades, which the SEC believes should be the case, will promote front running and significantly impact the liquidity available on those platforms that would provide for block trading and adversely affect the utility of the block trading feature. The MFA urged the SEC to allow the execution of block trades in “one participant to one participant” transactions that could then be “printed” on a swap execution facility.

Moreover, while mindful of the intent of Dodd-Frank to migrate as many swap transactions as possible onto swap execution facilities, the MFA asked that block size be defined in a way that allows a sufficient number of transactions to continue to take place bilaterally. The SEC has not set minimum amounts for block trades, but rather references block trade sizes as set forth in proposed Regulation SBSR relating to trade reporting.

SEC determinations relating to block size should take into account the varying characteristics of market liquidity for a particular instrument and the characteristics of the relevant class or product, said the association. In light of the importance of the block trade designation and the myriad of security-based swaps, reasoned the MFA, a one-size-fits-all definition for all security-based swaps is not sufficient. Rather, the MFA believes that a swap execution facility’s swap review committee should periodically determine what constitutes a block for each security-based swap or class that it trades. The MFA believes that this approach will permit the markets to adjust as trading develops.

Similarly, with respect to the determination of block trade sizes for security-based swaps, the MFA urged the Commission to obtain empirical evidence before establishing block trade levels for each swap or swap class in order to ensure that the regulations do not disrupt the markets or reduce liquidity. If the Commission elects to set block trade levels prior to obtaining appropriate data, it should set the initial levels for all swap classes sufficiently low such that they will not reduce market liquidity. The SEC could then adjust these levels over time as evidence supporting higher or lower thresholds becomes available

Section 763(a) of Dodd-Frank provides that transactions in swaps subject to clearing must be executed on an exchange or on a swap execution facility unless no exchange or execution facility makes the swap available for trading or the swap transaction is subject to a clearing exception. The MFA supports the SEC position that “available to trade” in this context must mean something more than the decision to trade or list a swap on a swap execution facility or an exchange.

The association similarly supports the requirement that a swap execution facility must use objective criteria established by the Commission to make a swap available to trade and periodically review swaps to determine the appropriateness of continued trading on the facility. This initial and ongoing review is critically important, said the MFA, since, once a swap is available to trade on an exchange or an execution facility, it can no longer trade in the OTC market.

The SEC proposes two alternative tests for determining whether a swap is available to trade. The first test compares the aggregate percentage of trading taking place in the swap on exchanges and execution facilities with the percentage of trading in the OTC market. Under the second test, the SEC would look to the overall volume in the swap, wherever executed, where a baseline trading threshold for each swap must be met, which could be a minimum number of transactions in the swap executed within a given period or a minimum notional value traded in the swap. Noting that security-based swaps do not currently trade on any exchange or execution facility, the MFA reasoned that the second test better determines whether a swap is available to trade.

The MFA also supports the use of a minimum liquidity threshold in the available to trade rubric because requiring a swap with limited liquidity to trade on an exchange or execution facility could further diminish its liquidity. Even more, the MFA asked the SEC to make the liquidity of the swap the determining factor of where the swap trades by mandating that a swap’s availability for trading must at all times be subject to a minimum liquidity threshold.