29 March 2011

ISDA: SEF rules should provide greater choice, access and liquidity to OTC derivatives market participants

Core SEF principles

ISDA believes that SEFs can play a positive role in the over-the-counter derivatives market by strengthening its infrastructure, helping prevent insider trading and other market abuse, and increasing transparency and access for smaller participants. To achieve this potential and become an effective marketplace, SEFs need to offer derivative users broad choice in trade execution at very low cost. SEFs should be structured to, among other things:

Provide maximum choice in trade execution to market participants;

Provide pre- and post-trade transparency while maintaining liquidity;

Have reasonable, tailored and product-specific block trade exemptions that reflect the risk of a transaction, instead of a “one size fits all” approach;

Grant access to a broad range of qualified market participants. Access rules should be objective and applied impartially;

Be flexible enough to allow business models to evolve over time;

Products required to be traded in SEFs should be limited to liquid, mature products;

Rules should not be simply imported from other, fundamentally different markets but should take into account the liquidity, average trade size and average trade frequency  of the derivative products, and the relative sophistication of the market participants.

It is also essential that individual SEFs are not discriminated against by central clearing organisations in terms of access and pricing.

Financial market structures and trading

In the paper, ISDA also noted the substantial differences between various segments of the financial markets and how trading has evolved in them. The exchange-traded futures market is characterised by a broad range of trading customers (including retail customers) meeting margin requirements to transact a small number of highly standardised contracts in relatively small amounts. As a result, liquidity in exchange-traded markets is relatively continuous in character.

By contrast, the number of potential buyers and sellers in the OTC derivatives markets is relatively small. Active participants are sophisticated institutions who extract very competitive pricing from multiple dealers. Trading is comprised of a wide array of less-standardised products. Trades are typically much larger in size and much less frequent. Liquidity levels are highly variable and depend, to a very large extent, on a dealer making prices for clients.

Different structures have also emerged for other market segments. This includes trading in US treasuries, arguably one of the most liquid financial instruments in existence. A large portion of trading in the so-called "on-the-run" treasuries, those most recently issued and most liquid, is conducted on electronic trading platforms. A substantial portion of trading in older, "off-the-run" treasuries is still done through wholesale brokers and directly between dealers. There is no requirement that any trades be made entirely on electronic platforms.

Review of current regulatory proposals

ISDA believes that regulatory proposals mandating the use of SEFs for derivatives trading should be based on the core principles outlined in the paper and the structure of the OTC derivatives markets. In its paper, the Association suggests several areas for improvement:

Determining whether a derivatives product is available for trading by a SEF:  The CFTC proposes to delegate this responsibility to the SEF and further proposes that if one SEF has made such a determination, all SEFs would be required to treat the swap as made available for trading.

The proposed rule does not, however, set out any specific criteria to determine whether a derivative product has the liquidity to trade. The CFTC should state that a contract subject to mandatory clearing does not automatically make it available for trading, and that the contract must also meet minimum liquidity and standardisation characteristics. 

The proposed rule also creates a misalignment of interest, in that SEFs will have every incentive to declare a product available for trading in order to capture market share. Furthermore, if a product trades very infrequently and every trade executed is known to the entire market as a result of SEF execution, participants will be very cautious in taking on positions. The result will be less liquidity and worse pricing for users. To eliminate this conflict of interest and its negative implications, the CFTC should make the "available to trade" determination - subject to public notice and comment.

Press release
Full paper 

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