ISDA has looked to help guide this process by formulating principles on central counterparty recovery, data reporting and, most recently, the centralized execution of swaps.
The introduction of Europe’s own trade execution rules in 2017 via the revised Markets in Financial Instruments Directive may eventually go some way to easing the problem. But there are significant differences between the existing SEF framework and the rules proposed by European regulators. In other words, an equivalence/substituted compliance determination between the two sets of rules is not a given, potentially exacerbating fragmentation.
ISDA believes regulators should abide by some high-level principles when developing and implementing their trade execution rules to maximise the likelihood of an equivalence/substituted compliance decision. In our Path Forward for Centralized Execution of Swaps paper, we set out three main factors. Importantly, regulators should only mandate certain products to trade on centralized trading venues based on objective criteria backed by data. Centralized trading may be appropriate for highly liquid products; it is not appropriate for illiquid instruments, and may discourage dealers from participating in these markets, depriving end users of important hedging tools.
Second, derivatives instruments subject to a trade execution mandate should be able to trade on different types of trading venues. Being overly restrictive will simply prevent derivatives users from accessing overseas pools of liquidity. Finally, trading venues must offer flexible execution mechanisms, rather than taking a limited, one-size-fits-all approach.
Based on these principles, ISDA believes targeted amendments to the US SEF rules are necessary. This would include changing the process for making mandatory trade execution determinations to ensure it is based on objective criteria and supported by data, rather than allowing SEFs to determine what is ‘made available to trade’. It would also mean granting greater flexibility in swap execution mechanisms rather than stipulating use of an order book or request-for-quote system that requires at least three market participants to submit prices.
ISDA believes that centralized trading venues provide a useful addition to derivatives market infrastructure and can help provide greater transparency on liquid products that are suitable for this type of execution mechanism. But the rules have to be consistent globally – and flaws need to be fixed as they emerge. The US SEF rules, in particular, can be improved, and regulators and market participants should not miss the opportunity to discuss where improvements can be made. ISDA’s buy- and sell-side members stand ready to contribute to this discussion. The ISDA principles are a first step, and adherence to them will encourage increased participation on centralized trading venues and will ensure these markets continue to work efficiently.
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