By Lene Powell, J.D.
Warning that different derivatives regulatory regimes between the U.S. and Europe have fractured liquidity in swaps markets, the International Swaps and Derivatives Association (ISDA) recommended that certain CFTC rules be revised to allow greater flexibility in the execution of swap trades. Specifically, the CFTC should revisit its “made available to trade” process that determines which swaps must be traded on-exchange, and ease restrictions on trade execution methods including executing trades by phone. The CFTC should also reconsider imposing SRO obligations on swap execution facilities (SEFs).
“ISDA and its members believe that targeted regulatory corrections in the US can improve the utilization of SEFs and enhance the likelihood of coordination with European transaction rules currently under development,” said Scott O’Malia, the current head of ISDA and a former CFTC commissioner.
ISDA cautioned that failure to reconcile rule sets between the U.S. and Europe could broaden market fragmentation and lead to intractable negotiations over which rule set should prevail. This will become even more challenging as Asian regulators begin to implement their own swap execution rules. For example, Japan’s execution and exchange registration rules are set to take effect this September.
Swap execution requirements. Following the 2008 financial crisis, the G-20 agreed on a number of objectives to reform over-the-counter derivatives markets. The accord required that all standardized derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate. After the Dodd-Frank Act, the CFTC adopted rules to implement this trade execution mandate. In Europe, the European Securities and Markets Authority (ESMA) is working on rules to implement the revised Markets in Financial Instruments Directive (MIFID II).
Under CFTC rules that took effect in October 2013, electronic venues that provide access to U.S. persons must register with the CFTC. In February 2014, the agency provided no-action relief allowing U.S. entities to continue trading on European multilateral trading facilities (MTFs) that had not registered as SEFs with the CFTC — as long as the European trading platforms met CFTC requirements. However, European venues found the requirements too onerous, so this workaround did not gain traction, said ISDA.
In addition, the CFTC implemented the trade execution mandate using a process called “made available to trade.” In this process, called the “MAT determination,” a designated contract market (DCM) or SEF can certify that a specific swap contract is available to trade. If the CFTC certifies the MAT determination, then that swap may no longer be traded bilaterally and must be traded on a DCM or SEF in the future. In theory, this should lead to a gradual migration of standardized derivatives trades from over-the-counter execution onto regulated derivatives exchanges. The first derivatives products were mandated under this process in February 2014 for certain interest rate products submitted by Javelin SEF. Rules regarding the trade execution mandate are not yet in place outside the U.S.
Fragmented markets. According to ISDA, as a result of these differing regimes between the U.S. and Europe, a clear split in liquidity has emerged. For example, in the euro interest rate swaps (IRS) market, the percentage of euro IRS transactions traded between European entities increased from 71% in September 2013, when the SEF rules went into effect, to 85% of transactions in December 2014.
Recommended revision of CFTC rules. In a paper called “Path Forward for Centralized Execution of Swaps,” ISDA called on the CFTC to make “regulatory adjustments.” First, the CFTC should make the MAT determinations itself, as ESMA plans to do, rather than leaving it up to self-certifications by SEFs. This would eliminate the competitive motivation for one SEF to force other SEFs to list a given product as a mandatory traded swap. Second, the MAT determination should be based on objective liquidity criteria — global minimum volumes of daily trading over a significant period of time for each swap, to be periodically re-evaluated.
In addition, said ISDA, the CFTC should eliminate unnecessary restrictions on swap execution mechanisms to bring CFTC rules closer to the contemplated ESMA regime. In particular, the CFTC should not force transactions to be traded by order book or minimum “request for quote” method, which may not be possible for certain swaps and could lead to artificially wide spreads. Regarding package trades, which consist of a combination of swaps that are subject to the execution mandate and swaps that are not, the CFTC should clarify that for a package trade to qualify as a block trade, only the MAT swap component needs to meet the block trade requirement. Also, the whole package transaction should be subject to a time delay.
Other recommendations included simplifying SEF confirmation requirements for non-cleared swaps traded on a SEF and reconsidering SEF financial resource and market monitoring requirements. SEFs should be allowed to include more assets in the financial resources calculation and should not be required to monitor other markets for manipulation, said ISDA.