Streetwise Professor

Frank-N-Dodd mandates that all cleared swaps trade on either a contract market (i.e., an exchange) or a “swap execution facility.”  There’s been a lot of uncertainty about just what a swap execution facility (“SEF”) is, but the bill provides enough clues to get a pretty good idea.

The short answer: a lot like an exchange.  A whole lot.

Some key points:

• An SEF must permit multiple participants to trade by accepting bids and offers made by multiple participants.  This means that an SEF must be a “many-to-many” execution platform.  A “many-to-one” platform, such as an electronic system in which a bank or broker-dealer posts bids and offers that customers can execute against wouldn’t qualify.
• They must permit “impartial access,” although that term is not defined.  But it suggests a mechanism in which no one can be excluded.  (Here the link to clearing is important.  If anybody is allowed to enter bids and offers that others can execute against, they must be effectively equivalent as potential counterparties.  Clearing standardizes–homogenizes–credit risk across counterparties.)
• The bill specifies that the goal of the section on SEFs is to promote pre-trade transparency.
• SEFs must establish and enforce rules to deter trade abuses.  They must have the capacity to investigate to detect rule violations.
• Relatedly, they must collect information that can be used to establish whether rule violations have occurred.
• They must permit trading only in non-manipulable swaps.
• They must monitor trading to ensure that rules are adhered to.  In particular, they must engage in real time monitoring of trading, and have systems to permit accurate and comprehensive trade reconstructions.
• SEFs must monitor trading in swaps markets to prevent manipulation.
• The bill states that SEFs “shall” impose position or accountability limits.
• SEFs are required to adopt rules to provide for the exercise of emergency authority.
• They are to make public “timely” information on price and trading volume and other trading data, as prescribed by the CFTC or the SEC (for security-based swaps). That is, they must offer “timely” post-trade transparency, but just what constitutes “timely” is an open question.  (Yet another thing on regulators’ plates.)

If you compare this list to the obligations imposed on contract markets (i.e., futures exchanges), you’ll see that SEFs are subject to almost all of the same obligations as contract markets.

In essence, SEFs must be a many-to-many execution platform that is also self-regulating entity that polices for trade practice violations and manipulation.  The combination of many-to-many with “impartial access” and extensive pre-trade and post-trade transparency effectively requires the creation of a public exchange; the mandated link between clearing and SEF execution is also very (futures) exchange-like.

It seems unlikely that “dark pool” like structures would meet these requirements; these are often not many-to-many, frequently don’t permit the making or executing against bids/offers (e.g., crossing networks), and offer limited pre- and post-trade transparency (hence the “dark” in “dark market”).  Traditional dealer-client execution wouldn’t cut it either: that’s not many-to-many.  Moreover, the real time trade monitoring and the ability to engage in accurate and comprehensive trade reconstructions seems to be an insuperable obstacle for voice brokers, meaning that effectively the bill requires the creation of electronic exchanges.

This suggests that (a) market participants will have a very limited choice of methods for executing transactions in swaps, and (b) these choices are far different than market participants have opted for currently.  Congress, in its infinite wisdom, is forcing pretty close to a one-size-fits-all trade execution system on the market.

The lack of diversity in execution methods compatible with the SEF mandate contrasts sharply with the incredible diversity of market participants.  It is well known that these diverse participants would like to have access to a variety of execution methods compatible with their particular needs.  For instance, those wanting to trade in very large quantities often prefer–and often strongly prefer–not to trade on many-to-many exchange-type markets because of information leakage, price impact, front running, etc.  The incredible array of execution platforms in equity markets testifies to this, as does the variety of derivatives execution methods, which range from order driven exchange markets to voice brokered markets to electronic dealing systems to telephone markets.

What is the rationale for restricting choice in execution?  The only hint of a justification is the desire for greater transparency.  But it is well known that  transparency has costs as well as benefits.  Mandating a high level of pre- and post-trade transparency just begs the question of why market participants would systematically choose the wrong level of transparency (i.e., a level that does not maximize the difference between costs and benefits), and why even if some market participants might profit from a sub-optimal level of transparency, competitive forces don’t prevail in overcoming the self-interest of a subset of participants.  Moreover, transparency isn’t the only thing that matters to market participants.  Other aspects of execution affect their costs and benefits as well.  A myopic focus on transparency alone ignores these other relevant dimensions.

The clash between the diversity of market participants and the my-way-or-the-highway SEF rules will result in chronic conflict in coming years.  There will be a demand, and likely a very strong demand, for the creation of alternative execution mechanisms to accommodate diverse trader needs.  There will be conflicts with regulators, and litigation, over whether these alternative mechanisms fall afoul of the SEF requirements.  There will be lobbying for exemptions, exceptions, and new laws permitting the creation of new kinds of facilities.

In 2005, I wrote that there was a 30 years war over securities market structure that was effectively started by the Securities Act Amendments’ mandate of a National Market System in 1975: that is now on its way to becoming a hundred years war (with the fallout from the Flash Crash just being the catalyst for another intense battle in that war).  The SEF mandate will spark a long running battle in derivatives market structure as well.  This is not the end of battles over derivatives market structure: this is the beginning.

The SEF rule is a Procrustean bed: an “arbitrary standard to which exact conformity is forced,” “a scheme or pattern into which someone or something is arbitrarily forced.”  Just why such conformity is optimal in a market with a wide range of buyers and sellers of different sizes, different trading objectives, different demands for immediacy and liquidity, etc., is hard to comprehend.  I understand that the nature of trading markets makes it that they are unlikely to be highly competitive (and I’ve written about that extensively in my academic work), and that as a result some inefficiencies (notably market power) can persist.  But competitive forces do exist, and especially given modern electronic trading technologies, it is possible for these competitive forces to respond to, and accommodate, diverse transacting preferences.

But rather than let market forces work, albeit imperfectly, Congress would rather play Procrustes, forcing traders large and small onto the same type of trading platform.

Where’s Theseus when you need him?