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September 23, 2013

More than a footnote | SEF October 2 CFTC deadline headaches

Previously SEFs and market participants assumed the SEF mandate would come in in a somewhat manageable fashion for a subset of clearing mandated products ("required transactions") with obligations only really biting for C2D trading late Q4 / early 2014.  However, interpretation of "footnote 88" buried on page 22 of the CFTCs final SEF rules published in July is causing seemingly frantic dialogue between SEFs, CFTC and participants due to the inclusion of "permitted transactions" in the language, effectively expanding scope beyond "required transactions" i.e. clearing-mandated rates and credit products to include all electronically traded OTC derivatives for other rates and credit products as well as whole other asset classes – FX, commodities, equities – previously not thought to be in scope.

In the flurry of its dialogue between itself and aspiring SEFs, dealers and buy-side participants, CFTC must be weighing the trade off between risking a reduction of electronic trading as a consequence of the October 2 deadline, granting a temporary delay or making a last minute rule adjustment to limit scope that expected by the market, with potential unintended consequences of a last minute change.  It will be interesting to see how this turns out.

Related links appended: SIFMA AMG: letter to CFTCGFMA: letter to CFTCRisk: Non-US platforms shun US banks (subs. required), Risk: Officials blindsided by CFTC footnote 88 (subs. required), Kevin on the street: October 2nd Should Be Boring (Unless the CFTC Kills Electronic Trading).

 

Prior Market Assumption

The prior market-wide assumptions on timing were that, on October 2 for clearing mandated products, existing trading on ECNs becomes SEF compliant i.e. Rates and Credit ECNs existing ECN participants only.  In other words, the objective was to make existing electronic trading for clearing mandated products SEF compliant. Then by December (or later) the SEF mandate would go live as a result of SEFs proposing some of their products as made available for trade and CFTC approving. Though in theory a SEF could "competitively" list a wide array of products they would not be popular with either buy side or sell side for doing so – therefore they will likely pick a narrow set of products to start.

This was already a challenging undertaking because not only of creating a SEF compliant rulebook and approving with all participants and making major changes to trading execution protocols, processes and systems but also because of the associated compliance payload beyond execution e.g. SEF reporting obligations – including backloading of historic trades and implementing NFA compliance monitoring activities. As an aside it has never been clear why it is necessary for SEFs should have any role in reporting transactions since CCPs could take care of cleared product and dealers any residual bilateral trading – both being risk bearing entities whereas SEFs are not.

 

Added Products

Adding asset classes previously out of scope altogether i.e. FX, commodities and equities considerably expands the industry wide effort adding new ECNs e.g. FXAll and whole new business lines in those asset classes in buy and sell side firms. Electronic trading is believed to exist for the following products: FX (NDFs, FX options), Commodities (precious metals options (since much of commodity swaps has already moved to swapfutures clearing and may therefore avoid SEF compliance). Whole ECNs in the FX, commodities and equities asset classes e.g. FXAll had previously not been planning to register and now face a blunt and rapid decision to either comply in a rush or back off OTC product execution for US persons.   Similar decisions are faced by the trading businesses and funds active electronically in these asset classes.

Adding non-clearing mandated Rates and Credit products could include the following products either traded on ECNs or single dealer platforms: Rates (inflation swaps, interest rate caps, floors and swaptions, cross currency interest rate swaps, muni swaps), Credit (CDS index tranches, CMB indexes, AB indexes). Though it is hard to collect useful current electronic trading volumes for these products, the potential impact is on both incumbent ECNs (e.g. Bloomberg, TradeWeb, MarketAxxess), the new IDB platforms (e.g. i-Swap, Trad-x) and some of the single-dealer platforms (e.g. Barx, Autobahn, Matrix).
 
 
What Can We Expect?
 
Doing this additional work in a rush for the products added to scope, especially when added to an already busy workload for the previously anticipated scope, creates considerable implementation risks with consequent market execution glitch potential.  If the CFTC sticks to its guns, we can maybe anticipate some temporary electronic trading curtailment where it includes one or more US persons being substituted by block trading / voice execution or by electronic execution between non-US persons where participants have that flexibility.  If this occurred, it would be hard to see it as anything but an unintended disruption.

 


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