The Dodd Frank regulations for derivatives typically cover any transactions undertaken under an ISDA Master Agreement, with a few exceptions. In what relates to swap transactions, the Commodity Futures Trade Commission (CFTC) will regulate swaps, while the Securities and Exchange Commission (SEC) will regulate security-based swaps.
Under the CFTC’s umbrella, the following will be covered: (i) interest rate swaps; (ii) foreign exchanges (FX) such as FX options, swaptions, and non-deliverable forwards (excluded from Dodd-Frank are FX swaps, FX forwards, and FX spot); (iii) index CDS; (iv) index equity derivatives; and (v) commodity derivatives. Â In turn, the SEC will regulate (i) single name CDS; (ii) narrow index CDS (9 names or fewer); (iii) single name equity derivatives; and (iv) narrow index equity derivatives (9 names or fewer).
The proposed regulations for swaps are complex but seem to be mostly driven by the regulators’ objective to increase market transparency. In order to accomplish this objective, regulators require the reporting of all swap transactions data to Swap Data Repositories (SDRs), including real-time public reporting of the timing, price, and volume of most swap transactions, among other requirements. At the other end, market participants try to reconcile trading anonymity with simultaneous regulatory compliance.
These regulations will significantly shape both how Swap Execution Facilities (SEF) aggregators will function in practice, and how widely these will be adopted by market participants. Among the new rules, those of greatest concern to market participants include the ability to voice trade, the 15-second rule, the definition of block trade, the requirements on best execution, and the requirement to send a Request for Quotation (RFQ) to five dealers. These are also the rules with the largest impact on liquidity fragmentation.
The Ability to Voice Trade and the 15-Second Rule
The new regulations have taken the position that though swap transactions are typically complex and infrequent, and there may be a need to speak to a broker by phone, voice trading on a SEF represents a limitation to the market’s ability to see all of the bids. Therefore, it asks for each trade to be displayed on a screen and in real time. The CFTC has put forward the 15-second rule which allows two parties to prearrange an order over the phone, but requires the order to be displayed on the open market for 15 seconds before it can be closed by the parties. The goal is to communicate the buyer’s and seller’s intentions to the market at the same time that other market participants are allowed to participate, thereby providing price improvement on the transaction. The 15-second rule will not affect the entirety of the market, as block trades are exempt from this rule.
There are potentially several consequences of having a prearranged order displayed for 15 seconds to the whole market, since it openly establishes the direction in which counterparties want to trade. In order to protect themselves, counterparties placing large orders (though not large enough to be classified as block trades) will likely divide them into smaller orders that will then be placed across the various relevant SEF’s. To be properly implemented, such a process will require the involvement of a Smart Automated Agency Broker (SABB).
The Dodd-Frank Act’s public reporting provisions require the CFTC to define a block trade for particular swap markets and contracts, as well as the adoption of adequate time delays for publicly reporting block trades. In regulated markets, it is common to treat a block trade differently.
The most recent CFTC proposal defines approximately one-third of the market as a block trade. This is important as block trades are exempt from the SEF trading requirement, meaning that these transactions can occur over the phone as they have traditionally been. These trades must still be reported, and the clearing mandate will still apply, but reporting will be delayed and there is no requirement of pre-trade price transparency on the screen.
The Commodity Exchange Act directs the CFTC to protect the identity of swap counterparties when swap transaction and pricing data are reported publicly following the pattern in the Dodd-Frank Act where Congress prohibited the disclosure of the identities of swap counterparties as part of the public reporting system. The CFTC recognizes that, in some instances, when swap data are publicly reported, market participants may be able to identify the parties to the swap due to unique features of the transaction. Therefore, the Commission proposes enhanced confidentiality protections by masking the notional amount of large swaps and by limiting the geographic details of certain swap transactions.
Five RFQ Requirements and Best-Execution Requirements
The CFTC’s 5 RFQ rule requires all RFQs to be sent to at least five different liquidity providers. The SEC has countered with a proposal that RFQs must be sent to one or more liquidity providers. Independently of what the final number will be, this requirement will impact the way SAAB operates; depending on the product, the regulator may vary and SAAB would need to have this knowledge in order to act accordingly. For example, index CDS fall under the CFTC’s rules while single-name CDS fall under the SEC’s rules.
SEF best execution rules, commonly known as order interaction rules, will require SEFs to ensure interaction between their RFQs and Central Limit Order Books (CLOBs). For example, before an RFQ can be acted upon, any better-priced liquidity in the order book would need to be taken out, with the objective of facilitating execution efficiency.
The document from the ABA Committee on Futures and Derivatives Law Annual Meeting titled SEFs, DCMs and FBOTs “ The Regulation and Oversight of Trading Platforms, presents in great detail several of the relevant aspects of the current proposed regulation and discusses the main open issues.