The US Commodity Futures Trading Commission (CFTC) legislated that most swaps be traded on swap execution facilities (SEFs), processed through central clearing firms and reported to trade repositories, under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The CFTC is expected to confirm later this year that this process is also mandated for FX options and non-deliverable forwards (NDFs).
Platforms rushed to register as SEFs before the October 2, 2013 deadline, and today 24 have signed up with the CFTC.
SEF trading volumes were initially paltry, but the latest figures compiled by consultancy firm Capco show volumes for the week commencing March 19 reached $1,984 billion. FX derivatives trading only accounted for 9% of that overall weekly figure, as there is still no clear regulatory mandate to trade them on SEFs.
|Source: Capco. Click here to enlarge image.|
It is possible to trade NDFs on an SEF and clear them, but if regulators were hoping NDF users would embrace SEFs they were sorely mistaken.
One market participant at an SEF describes the market’s reaction using the analogy of the Scottish mythical monster Loch Ness. “It is as if the Loch Ness monster crawled out of the lake and called itself an SEF, and everyone is running away,” he says. “Has there been a race for people to come and trade NDFs on SEFs? Hardly.”
In the swap market, some are so keen to avoid trading on SEFs they have manipulated the CFTC’s rules to their own end. The regulator deemed that the swaps market should move to a central limit order-book model, which requires many buyers and sellers of similar swap instruments to function. However, crucially, a swap can be created with any start and end date.
It is therefore easy to avoid trading on an order book altogether by modifying the dates of the instrument, says John Wilson, global head of OTC clearing at brokerage firm Newedge. For example, instead of buying a standard three-year swap, it is possible to buy a three-year and one-month swap.
“There cannot be an order book for every obscure swap tenor in every currency,” says Wilson.
The underlying spirit of the CFTC’s move to a central limit order-book model is to boost the number of liquidity providers, but, ironically, this is proving to be unwelcome, says Zohar Hod, global head of sales at SuperDerivatives, a derivatives pricing firm and registered SEF.
“There are so many SEFs that for a buy-side firm or a dealer to decide which SEF they will provide liquidity to or take liquidity from is difficult,” he says.
Customers who wish to access an SEF directly can face a bureaucratic legal on-boarding process. “I suspect that we will see major consolidation of SEFs in the near future,” says Hod.
Market participants are also anxious about the future effects of an extraterritoriality loophole in the CFTC’s regulation.
The mandate to trade on an SEF extends to non-US counterparties that trade with a US counterparty, but a US subsidiary that is separately capitalized and regulated outside the US is considered a ‘non-US entity’. A UK asset manager could trade with an American bank through its UK subsidiary and avoid executing on an SEF altogether.
However, this has created the unintended consequence of two pools of liquidity, which the CFTC underestimated, warns David Clark, chairman of the Wholesale Markets Brokers’ Association. A similar bifurcation phenomenon occurred in the euro-dollar market in the 1960s.
“The bifurcation in liquidity between US and non-US markets is probably greater than regulators expected,” he says. “Liquidity in some products, such as NDFs, has dried up considerably.
“Where illiquid products are concerned, bifurcated liquidity is bad for the market. It is potentially a problem.”
Regulators are keen to introduce clearing for FX derivatives, yet no clearing house is able to offer this service. In addition, none is connected to the settlement service CLS.
“A key part of the settlement service, which is fundamental to the running of FX markets, is missing,” says Wilson.
However, an even greater problem exists, that could arguably be compounded by moving even more financial products, such as forex derivatives, onto the clearing model.
CFTC rules demand clearing brokers guarantee all orders on SEFs, but a liquidity provider might stream thousands of quotations which are characterized as ‘live orders’. In reality, only a fraction of those orders will be executed, but clearing firms have to stand clear to accept every single quote, says Newedge’s Wilson.
Central counterparties now take the view that either the client or the clearing firm must have enough collateral to cover the transaction at the point of clearing. Any intraday spikes in margin requirement must be funded.
“However, necessary funding is neither cheap nor abundant, putting further strain on the market structure,” warns Wilson.
Market makers such as banks already self-clear and can fund their own activities, but a new non-bank entrant would have to enlist a clearing firm to guarantee all their orders, creating a barrier to entry.
It remains to be seen how exactly regulators will rule on FX derivatives, but market players remain hopeful the CFTC will address their concerns.
Vikas Srivastava, CEO of swap execution facility, Integral SEF, says: “The whole derivatives landscape is changing, so, to some extent, I am not surprised that there are teething issues. The CFTC is open to working with the industry to work these issues out and provide guidance.”
The CFTC declined to comment for this article.