SEFs on Board: Connecting the (OTC) Derivatives Market

Hear Radi Khasawneh, TABB Group, and Stephen Anikewich, NICE Actimize, discuss swaps and OTC regulations and enforcement at a complementary webinar on June 24th. Register here: Over-the-Counter & Under Scrutiny: The Regulatory Focus on Swaps & OTC Derivatives

In the past, futures exchanges have been very effective at instituting policies and procedures that generally prevented the mishaps of individual traders from inadvertently hurting other traders, their firms, and market integrity itself. As we have learned, Dodd-Frank’s new rules for over-the-counter (OTC) swaps are designed to make them trade more like futures, which has boosted overall transparency. “Swap” is a broad term for many types of financial derivatives directly agreed between two parties, including credit default swaps and currency forwards. The most common is the interest rate swap, which allows people to transform floating-rate debt into fixed-rate debt and vice versa.

The spirit behind all of these new rules is that regulators want greater transparency coupled with central counterparty clearing processes in place. If swaps are traded on exchanges rather than negotiated bilaterally, regulators and market participants should have an easier time measuring and containing systemic risk. As a result, there will be new best execution models developed as a by-product of this increased transparency.

What is now creating greater impact and playing a role in shaping these markets is the new Swap Execution Facilities (SEFs), created out of Dodd-Frank, to facilitate transparency in the OTC derivatives space. The fundamental purpose of the SEF is to connect market participants together, and these SEFs perform a variety of functions, including price discovery, order matching, unique swap identifier generation, submission of trades to the designated central counterparty, and trade reporting to swap data repositories.

While OTC swaps were loosely regulated for years before the financial crisis, the concern now addresses another issue: did the regulatory pressures swing too far to the right and actually hurt the markets and bring down liquidity? The bottom line is, there must be a “level playing field” between futures and the swaps markets as was established in other asset classes such as the equity and fixed income markets years ago.

The ongoing debate now is this – will the regulatory rules stifle competition among swaps trading platforms and clearinghouses? A particular concern centers around the margin requirements for futures and whether or not they will be lower than for swaps contracts, all unanswered questions as of right now.

How these markets will look and operate in the long term will begin to define itself within the next 6-12 months. The key trends in the coming months include OTC and exchange-trade derivative convergence, Swap Execution Facility (SEF) convergence, and SEF aggregation, as well as new lines of business forming and hopefully creating new opportunities for growth down the road.

With convergence a key word here, the single largest area of this convergence is expected to lie in the impact of electronic trading on the OTC markets. Of course, mandatory electronic trading is still in the beginning stages, and firms are dealing with increased regulatory rules and regulations while still trying to run a business. While a lot is still unclear, one thing that is certain is that regulators want to ensure transparency and a level playing field to directly help all market participants who trade in these specialized markets.

This transformation is long overdue; however, transformation is the trend in all assets/markets across the globe. One thing all of these issues has in common, wherever you trade, is that they are all working together to hopefully prevent another financial crises from occurring and from causing businesses seeking to build new opportunities to be prevented from getting a foothold. Some of the newest, and perhaps most effective, preventative measures and regulatory solutions are certainly a step in the right direction to building a more robust and secure market structure. It is good to see the futures market the focus of such regulation and attention.

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