ISDA survey: Footnote 88 and Market Fragmentation

18 December 2013

SEF compliance and the Footnote 88 interpretation are having an impact on the nature of trading and its volumes in the OTC derivatives markets. Liquidity has fragmented, more trades are being done bilaterally and via voice, and trading between US persons and non-US persons is disrupted.

Earlier this year, the US Commodity Futures Trading Commission (CFTC) required that swap execution facilities (SEFs) with temporary SEF registration status come into full compliance with all applicable SEF rules beginning on October 2, 2013.

Originally, those rules were thought to apply only to transactions that would be required to trade on a SEF. However, confusion over Footnote 88 and the definition of a US person have resulted in liquidity concerns from market participants. Footnote 88 states that "a facility would be required to register as a SEF if it operates in a manner that meets the SEF definition even though it only executes or trades swaps that are not subject to the trade execution mandate." This means that the SEF rules would apply to any transaction the SEF offered, whether or not that transaction is mandated to trade on a SEF.

These concerns prompted ISDA to conduct the SEF Market Fragmentation Survey to obtain a clear picture of potential market disruption or fragmentation resulting from SEF rule implementation.

The ISDA survey’s findings reveal:

• Liquidity has been fragmented across platform and cross-border lines resulting in separate liquidity pools and prices for similar transactions.
• Several participants revealed that total derivative trading volume measured as a percentage of notional amount decreased from October 2, particularly in credit and foreign exchange derivatives.
• 84% of survey participants believe non-US persons are choosing not to trade on SEF platforms as a result of CFTC rules coming into effect in all swap categories: interest rate, credit, foreign exchange, equity and commodity derivatives.
• 68% of participants believe trading activity with US persons is being reduced or has ceased as a result of the October 2 rule. Over half of the responses indicate the presence of market fragmentation, such as the formation of separate liquidity pools for US persons.
• 61% of participants believe trading has been redirected from electronic to voice trading as a result of the CFTC-SEF rules coming into force.
• Roughly half of the participants believe fragmentation resulting from the SEF rule has led to different prices for similar types of derivative transactions.

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