03 February 2014

FN: How the EU can avoid own goals on swaps reform

Under MiFID, ESMA must work out the technicalities of how trading of OTC derivatives is to move to electronic venues. ESMA is expected to put a consultation paper to the industry by May.

The new US derivatives trading venues – swap execution facilities – were created in October under rules introduced by the Commodity Futures Trading Commission. Critics of the CFTC say that its new rules created conflicts of interest, suffer from potential loopholes and do not take key aspects of current swaps trading practices into account. Pete Best, chief operating officer of Icap’s SEF, said: “There have been lots of challenges. There was a need to undertake many different streams of work in a relatively short period of time to support the required SEF infrastructure.” In the US, 22 firms, including a number of trading venue operators and interdealer-brokers, are operating or seeking approval for SEFs.

Critics say the regulator has too little power to reject such applications. Operators first submit a “made-available-to-trade”, or MAT, determination to the regulator. Provided the application meets the terms of the Commodity Exchange Act the CFTC cannot reject it.  John Wilson, global head of OTC clearing at broker Newedge, said: “The process by which products are determined for mandatory trading is prompted by venues that have a self-interest in forcing people to trade on them. There is an evident conflict of interest in allowing trading venues to lead the debate on what needs to be traded on SEFs.”

Critics also say that the way the products that must be traded on a SEF are defined provides a way to avoid the requirement. The Mat submissions that have been approved for interest rate swaps include only contracts with specific tenors, meaning the contracts last a certain number of calendar years. Outside those dates, SEF trading would not be mandatory.

Another issue is the handling of package trades – a group of several contingent swap trades commonly used by the buyside to achieve a specific exposure or hedge. The CFTC’s attempt to stipulate that a swap subject to its trading mandate must be traded on a SEF, even if it is part of a package, may actually increase risk by splitting the package.

As OTC derivatives reform leads to more swap trades going through clearing houses, concern has arisen over how the market would react if a clearing house faced financial difficulty. Moving swaps to electronic markets presents a similar problem through the use of limit checking hubs. Under CFTC rules, the credit limit of a firm trading a swap must be verified before the product can be traded on a SEF and cleared. A credit checking hub developed by Traiana is currently the dominant service and is used by the largest banks as well clearing houses and a number of SEFs.

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