Are you as puzzled as I am by the mild brouhaha over the CFTC's new swap execution facility rules? Basically the rules require that most swaps be traded on pseudo-exchange-y-type things called "swap execution facilities," which are run either by an order-book system or a "request for quote" system. The RFQ system would require anyone wanting to trade to send an RFQ to at least 3 (2 for "an initial phase-in period") potential counterparties. The original proposal was for that to be five counterparties. The revised proposal has caused a striking amount of rage, as various people have confused themselves into thinking that of course it's obvious that every transaction should be an auction among five potential counterparties. Presumably few of those people orient their daily life that way. I don't, anyway; I get lunch at Chipotle every day because it's next door to Dealbreaker HQ.1
On the other hand people who think that customers should choose how many quotes to get don't like the 3-quote compromise either. Here's a SIFMA guy whining about it, and he doesn't seem all that wrong:
SIFMA’s Asset Management Group continues to believe that any minimum-bid requirement will tie the hands of portfolio managers who already have a fiduciary obligation to serve the best interests of their clients. Requiring portfolio managers to broadcast their trading position more widely than they would otherwise choose could negatively impact the prevailing price of their trades, making it more expensive and difficult to hedge their clients’ risk. SIFMA strongly believes that professional investment managers, and not the government, should determine appropriate trading strategy.
The thing that trading is is, deciding how broadly to expose your order. Wider exposure gets you more and potentially better bids, but at the risk of getting front-run or picked off or otherwise abused.2 I realize that I won't persuade everyone by quoting a trading textbook but here:
Your order submission strategy is the most important determinant of your success as a trader.
Imaginably people who trade for a living are better at it than the CFTC is? They seem to think so; here is a strange passage from DealBook:
The banks also benefited from some unlikely allies, including large asset managers that buy derivatives contracts. While money managers may seem like natural supporters of Mr. Gensler’s plan [to "make all bids for derivatives contracts public"] — and some in fact are — the industry’s largest players already receive significant discounts from select banks, providing them an incentive to oppose Mr. Gensler’s plan.
The companies cautioned that, because Mr. Gensler’s plan would involve a broader universe of banks, it could cause leaks of private trading positions. The plan, the companies said, would not necessarily benefit the asset managers.
The explanation in which the asset managers were lying about their concerns about trading strategies, because they were bribed by dealers with "significant discounts," does not seem like it could be the right explanation.
As far as I can tell everyone who is either a swap dealer or a swap customer prefers to leave this question to the swap customers rather than the CFTC. Which ... makes sense? Nobody exactly knows how the SEF thing will shake out but intuitively contracts that trade all the time should probably trade in some sort of order-book system; if your order is likely to be hit or lifted in a reasonable time then you might as well put it in the order book and, voilà, swap pricing transparency for all. Contracts that trade once a day are less likely to work that way, even if you want them to, and so seem likely to end up in RFQ systems. Contracts that trade once a day are less likely to have five useful dealers; requiring five quotes would seem to prohibit trading in those contracts.
Prohibit trading on the SEF, that is. My perverse favorite part of the rules is the "made available to trade" stuff, which we can talk about a little in the footnote.3 But the point here is:
- If a swap doesn't trade at least semi-liquidly on any SEF, then
- you can just trade it bilaterally: customer calls one dealer, or two, or however many they want, get quotes, and trade it all with no transparency at all.
So if the CFTC had required five quotes, and customers couldn't practically get the five quotes in a given product, they just wouldn't trade that product on an SEF. And they wouldn't be forced to. They'd just get however many quotes they wanted over the phone from dealers, and trade bilaterally like they do now.
You can readalotofclaimsthat the 2-3 quote thing is bad for the world and driven by, basically, corruption and regulatory capture, but none of those claims come with arguments attached.4 Basically it's like "oh well Bart Chilton opposed scaling back the requirement, and he quoted Churchill so he must be right." That is the sort of nonsense up with which I will not put.5
What is going on? The pricing-transparency purpose of requiring asset managers who want to transact quickly and quietly with one dealer, to instead put out RFQs to three or five dealers, is ... somewhat opaque. This doesn't seem to be aimed at the customer-protection or market-transparency purposes of the SEF rules. Presumably the controversy is over something else. You can get a sense of it here:
Roughly five years after previously unregulated derivatives helped fuel the downfall of large financial institutions and led to a global financial crisis, the rules to be voted on by the five-member commission ...
Yet allowing such a large and important market to operate as a private club came under fire in 2008. Derivatives contracts pushed the insurance giant American International Group to the brink of collapse before it was rescued by the government. ... “It’s important to remember that the Wall Street oligopoly brought us the financial crisis,” said Dennis Kelleher, a former Senate aide that now runs Better Markets, an advocacy group critical of Wall Street.
The sense seems to be: you need to get five quotes not because that will get you a better price or improve the functioning of the swap market, but because then maybe you'll end up trading with a bank other than the five banks that "hold more than 90 percent of all derivatives contracts." If you force competition, maybe someone will be able to challenge the big banks. And if that happens, then maybe that will dissipate some of the risk from those banks.
I ... guess? It seems like a pretty inefficient way of doing that. For one thing, it addresses dealer but not customer concentration: AIG wasn't "pushed to the brink of collapse" by non-transparent pricing in its swaps contracts but rather by having too many of them and being wrong about them. For another, it doesn't actually address dealer concentration: forcing someone to ask for five quotes might force them to send an RFQ to a smaller dealer, but it doesn't force them to trade with that dealer. Of course, maybe they would: maybe an interloper with a smaller balance sheet and less experience and order flow in a given product would pick up market share just by being forcibly included on RFQs and consistently undercutting everyone else on price. I'm not sure that interloper would necessarily add much to market stability though.
“If someone told me I needed to shop five different places for a pair of jeans, I don’t see how that would help me,” said Gabriel D. Rosenberg, a lawyer at Davis Polk, which represents Sifma and the banks.
2."Front-run" here being a somewhat composite term, meaning more like "exposing your swap order more broadly increases the risk of the dealer you ultimately buy from being front-run in the hedging market, thus increasing the price they charge you." Incidentally some news reports seem to suggest that the RFQ sent to 2 or 3 or 5 dealers would somehow be exposed to the entire market pre-trade, which just seems false.
3.What the Dodd-Frank Act says is that if a swap is required to be cleared, and if any swap execution facility "makes the swap available to trade," then you've got to trade it on a swap execution facility.a This would seem to lead to a marvelous bootstrapping possibility: find a not-particularly-liquid swap that trades occasionally, open a SEF in your basement, list that swap for trading, and force everyone to trade with you.
The CFTC seems to have closed off that possibility by requiring that an SEF determine "whether the swap execution facility has made a swap available for trading" by looking at liquidity, etc., in that swap.b Just listing the swap isn't enough; you have to actually have some trading.
Fun questions to ponder are:
- Did the CFTC go too far by requiring liquidity on the SEF before forcing everyone to trade on the SEF? Should the rule have been "as long as an SEF offers to trade something, you gotta trade it there, no matter how shitty their platform"? That seems to have been what Congress said, so.
- Alternately: did they not go far enough by basically leaving the decision in the SEF's hands? Republican CFTC Commissioner Scott O'Malia thinks so:
I have deep reservations about the process that the Commission is proposing for “making a swap available to trade.” ... In essence, the rule allows a SEF or a DCM to make a made available-to-trade determination based solely on factors it deems relevant, while ignoring other considerations that may be of vital importance to the trading liquidity of a particular contract. The Commission needs to require more than a simple “consideration” of these factors.
(A) IN GENERAL.—With respect to transactions involving swaps subject to the clearing requirement of paragraph (1), counterparties shall—
(i) execute the transaction on a board of trade designated as a contract market under section 5; or
(ii) execute the transaction on a swap execution facility registered under 5h or a swap execution facility that is exempt from registration under section 5h(f)
of this Act.
(B) EXCEPTION.—The requirements of clauses (i) and (ii) of subparagraph (A) shall not apply if no board of trade or swap execution facility makes the swap available to trade or for swap transactions subject to the clearing exception under paragraph (7).
b.Final rules aren't out yet but from the proposal:
(b) When conducting reviews and assessments regarding whether the swap execution facility has made a swap available for trading, a swap execution facility may consider:
(1) The frequency of transactions in this or similar swaps;
(2) The open interest in this or similar swaps; and
(3) Any other factor requested by the Commission.
4.Except this one, which is an argument:
Imagine this—an institutional investor or corporation gets favors from a bank to cultivate a relationship and in return enters into a special deal on a big swap transaction. They can transact on the SEF by putting out the "request for quotes" to one other party. It is easy enough to frustrate the law by picking the second request recipient tactically. The swaps markets are balkanized and each tends to be dominated by one or two banks.
But even worse, it is an obvious invitation for collusion between the two recipients of the request to assure the outcome. This kind of collusion has been rampant on Wall Street for decades. But we need go no further back in history than the recent disclosure on rigging LIBOR, the interest rate that underpins $350 trillion of derivatives contracts and even more conventional financial transactions. If the banks can rig LIBOR, rigging SEF transactions is child’s play.
I am not impressed by this? It's, like, "asset managers will corruptly seek the worst price to reward their dealer buddies, and dealers will illegally collude with each other to suppress prices." My priors are that that's not particularly common but I could be wrong. Note that you don't hear a lot of claims that this happens in current, less-transparent markets. People screw clients, sure, but not collusively. And of course non-corrupt asset managers can avoid it by just asking for five quotes themselves. Or, like, thirty; go nuts, nothing's stopping you from getting as many quotes as you want. The corrupt asset managers, I mean, sure, whatever.
This set of three trading rules—SEF, MAT, and Block—have, to put it mildly, been a long time coming. What is in front of us today has parts I like, parts I don’t like—that’s what compromise means. As Churchill said, “The English never draw a line without blurring it.”
Careful observers will note that the CFTC is American.