[Senate Hearing 112-288]
[From the U.S. Government Publishing Office]
S. Hrg. 112-288
EMERGENCE OF SWAP EXECUTION FACILITIES: A PROGRESS REPORT
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
A PROGRESS REPORT ON THE EMERGENCE OF SWAP EXECUTION FACILITIES
__________
JUNE 29, 2011
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.fdsys.gov /
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73-132 WASHINGTON : 2012
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
William Fields, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
MIKE CRAPO, Idaho, Ranking Republican Member
CHARLES E. SCHUMER, New York PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
HERB KOHL, Wisconsin JIM DeMINT, South Carolina
MARK R. WARNER, Virginia DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota
Kara Stein, Subcommittee Staff Director
Gregg Richard, Republican Subcommittee Staff Director
(ii)
C O N T E N T S
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WEDNESDAY, JUNE 29, 2011
Page
Opening statement of Chairman Reed............................... 1
Opening statements, comments, or prepared statements of:
Senator Crapo................................................ 2
Prepared statement....................................... 36
WITNESSES
Kevin McPartland, Director of Fixed Income Research, TABB Group.. 4
Prepared statement........................................... 36
Responses to written questions of:
Senator Toomey........................................... 76
Neal B. Brady, Chief Executive Officer, Eris Exchange, LLC....... 6
Prepared statement........................................... 39
Responses to written questions of:
Chairman Reed............................................ 78
Senator Toomey........................................... 80
Ben Macdonald, Global Head of Fixed Income, Bloomberg, L.P....... 8
Prepared statement........................................... 53
James Cawley, Chief Executive Officer, Javelin Capital Markets... 10
Prepared statement........................................... 59
William Thum, Principal and Senior Derivatives Counsel, The
Vanguard Group, Inc............................................ 27
Prepared statement........................................... 60
Stephen Merkel, Executive Vice President and General Counsel, BGC
Partners, Inc.................................................. 29
Prepared statement........................................... 62
Chris Bury, Cohead of Rates Sales and Trading, Jefferies &
Company, Inc................................................... 31
Prepared statement........................................... 73
Additional Material Supplied for the Record
Statement submitted by the Investment Company Institute.......... 85
Paper submitted by the International Swaps and Derivatives
Association.................................................... 93
Letter submitted by Stephen Merkel, Chairman, Wholesale Markets
Brokers' Association........................................... 114
(iii)
EMERGENCE OF SWAP EXECUTION FACILITIES: A PROGRESS REPORT
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WEDNESDAY, JUNE 29, 2011
U.S. Senate,
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 9:32 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Jack Reed, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. Let me call this hearing to order. Senator
Crapo and I want to welcome our witnesses. This morning we are
going to focus on the topic ``Emergence of Swap Execution
Facilities: A Progress Report.''
The financial crisis revealed some significant weaknesses
in our financial sector. One of the most problematic was the
over-the-counter derivatives market. As a result, the Dodd-
Frank Wall Street Reform and Consumer Protection Act of 2010
developed new rules for the OTC market to insulate both the
U.S. economy and the American taxpayer from any future
extraordinary losses in this area.
In particular, Dodd-Frank mandated that all cleared trades
be executed either on an exchange or on a new trading platform
called a swap execution facility, or SEF. The Dodd-Frank Act
defined a swap execution facility as ``a facility, trading
system, or platform in which multiple participants have the
ability to execute or trade swaps by accepting bids and offers
made by multiple participants in the facility or system through
any means of interstate commerce.''
The development of SEFs should transform the current
trading marketplace by providing significantly greater pre- and
post-trade transparency for regulators and market participants
alike.
In addition, once a trade has been completed, a
counterparty should be able to compare the price it receives on
a particular trade with the price of similar trades that buy
and force similarly standardized products. This information
should also be useful to those analyzing the effectiveness of
hedging strategies. Finally, increased transparency in the new
trade reporting requirements will give regulators better
information and additional tools to monitor the swaps market
for possible market manipulation.
The Commodity Futures Trading Commission and the Securities
and Exchange Commission have both proposed rules to implement
the SEF provisions of the Dodd-Frank Act for swaps or security-
based swaps under their respective jurisdictions.
In addition, because standardized swaps that are cleared
must be traded on an exchange or a SEF, Dodd-Frank Act requires
clearinghouses to provide open access to various execution
venues. Both the SEC and CFTC have proposed rules that
implement the open access requirements of the Dodd-Frank Act to
encourage competition in the SEF and clearinghouse market.
All of us have a vested interest in making sure these new
derivatives swap execution facilities function safely,
efficiently, and fairly. Hopefully, our hearing this morning
will help us understand best how we can accomplish this
objective.
Senator Crapo and I have invited witnesses that represent a
variety of opinions and perspectives to our hearing.
Unfortunately, due to scheduling difficulties, the large dealer
bank we invited was unable to appear before the Subcommittee
today. Nonetheless, we hope the conversations we have this
morning spur deeper thought on these complicated issues, and we
encourage participation by written testimony or comments after
the fact, and that both industry and policy makers continue to
work together to make our swaps markets the most transparent,
competitive, and efficient in the world.
I look forward to hearing from our witnesses, and at this
time I would like to recognize the Ranking Member, Senator
Crapo. Senator Crapo.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Thank you very much, Senator Reed, and I
appreciate the opportunity we have to work together on this
Committee and also the fact that you have noticed this hearing
with regard to SEFs.
There are a number of different electronic trading models
that could be potentially used for derivatives trading
depending on the final rules the SEC and the CFTC and
international regulators adopt. But I want to focus just on a
couple of concerns that I see us facing right now in our
current posture.
While Title VII of the Dodd-Frank Act states that the SEC
and the Commodity Futures Trading Commission shall consult and
coordinate to the extent possible for the purpose of assuring
regulatory consistency and compatibility, it appears that the
lawyers for the two agencies, or maybe the other personnel at
the agencies as well, have not been able to agree on what these
terms mean.
We should not then be surprised that the two agencies have
proposed inconsistent approaches to the same rule sets. For the
swap execution facility rules, the SEC approach, in my opinion,
is a more principles-based approach and is in general far less
prescriptive than that of the CFTC. While the Dodd-Frank Act
missed a great opportunity, in my opinion, to merge the SEC and
Commodity Futures Trading Commission and stop the bifurcation
of futures and securities markets--we lost that opportunity
then--we should at least continue to push for more coordination
and consistent rules.
Swap execution facilities are likely to dually register
with both agencies, and it makes a lot of sense for the two
regimes to be consistent.
While I applaud the SEC for taking a more flexible approach
relative to the CFTC, both agencies need to make their rules
more accommodative of the different types of SEFs to provide
the maximum choice in trade execution to market participants.
Under the current CFTC SEF version, the proposed rule
requires swap users to request prices from no fewer than five
dealers at a time. This is generating a lot of controversy from
the end user community, which argues that it may ultimately
serve to unnecessarily disadvantage end users by limiting their
ability to chose appropriate numbers of counterparties and the
mode of execution in the way that they deem to be the most
efficient and effective to hedge their commercial risk.
Since Dodd-Frank stipulates that the transactions required
to be cleared must also be evaluated on a SEF or designated
contract market, there is significant interplay between the
clearing, trading, and definition of block trades. According to
the end users, this could create a problem for some less liquid
trades that would be suitable for clearing but not necessarily
for trade execution.
I have also been advised that the SEC's SEF approach is
more consistent with what the Europeans are looking at, but I
have not actually seen the exact comparison.
If we want to find a common international framework in
order to avoid regulatory arbitrage and avoid competitive
disadvantage to our markets, we need to provide greater
coordination and harmonization to get the rules right rather
than rushing them through.
This is just a short summary of some of the issues that I
am concerned about that I think we ought to focus on in today's
hearing. I also welcome today's witnesses, and I look forward
to what we will hear.
Chairman Reed. Well, thank you very much, Senator Crapo.
And before I ask Senator Corker if he has comments, let me
associate myself with your comments about collaboration, the
joint regulation between the SEC and CFTC. I hope one of the
results of this hearing is to be able to focus their attention
on coming up with a consistent rule for both agencies rather
than two distinct sets of rules. I think that is going to--the
intent clearly, as you point out, in Dodd-Frank was to have one
set of consistent, appropriate, flexible rules. And I, again,
second your very insightful comments in that regard.
Senator Corker, do you have any comments?
Senator Corker. Thank you, Mr. Chairman. I am looking
forward, as usual, to the testimony, and I appreciate you
having the hearing.
Chairman Reed. Thank you very much.
Let me introduce the first panel. Our first with is Mr.
Kevin McPartland. He is a principal and director of fixed
income research at TABB Group. Mr. McPartland joined the TABB
Group as a senior research manager in 2007 from a management
consultancy, Detica, where he was a senior manager in the
Global Financial Markets Division. Prior to joining Detica, he
held positions at JPMorgan Chase in equities and futures and
options, managing development, and implementation of electronic
trading systems. Thank you.
Our next witness is Mr. Neal Brady. He is the chief
executive officer of Eris Exchange. Prior to cofounding Eris
Exchange and assuming the role of CEO, Mr. Brady served as
managing director of business development at CME Group, where
he was responsible for the growth of the CME Group's OTC and
global business. Prior to CME, he founded and served as chief
executive officer of Liquidity Direct Technology, a leading
platform for interest rate derivatives trading that was
acquired by CME in January 2004.
Our next witness is Mr. Ben Macdonald. He is a naturalized
U.S. citizen residing in New York City. Thank you for that, Mr.
Macdonald. He is the global head of fixed income products for
Bloomberg, L.P., a position he has held since May 2010, and in
that capacity he heads up Bloomberg's Swap Execution Facility
Development Initiative. Prior to joining Bloomberg, he worked
at Goldman Sachs managing the credit default swap operations
team and at JPMorgan Chase where he held several positions in
interest rates derivatives.
Our final member of the panel is Mr. James Cawley. Mr.
Cawley is the chief executive officer of Javelin Capital
Markets, an electronic execution venue for credit derivatives
and interest rate swaps. Javelin expects to register as a swaps
execution facility. He is also the founder of the Swaps and
Derivatives Market Association, an industry trade group of
several dealer and clearing brokers that advocates for
successful OTC derivatives clearing, open access, and
transparency. Mr. Cawley has 20 years of derivatives sales and
trading experience, working for many years in the credit
markets for Salomon Brothers, Lehman Brothers, and Bank of
America. Most recently, Mr. Cawley ran IDX Capital, a credit
derivatives interdealer broker.
I thank you all for being here this morning. Senator
Merkley, do you have any opening comments?
Senator Merkley. No.
Chairman Reed. Thank you. I would ask the witnesses to
limit their remarks to 5 minutes. Your written statements will
be completely incorporated into the record, so there is no need
to read them.
Mr. McPartland, if you would begin, please. Thank you..
STATEMENT OF KEVIN McPARTLAND, DIRECTOR OF FIXED INCOME
RESEARCH, TABB GROUP
Mr. McPartland. Chairman Reed, Ranking Member Crapo, and
Members of the Subcommittee, thank you for inviting me here
today to discuss progress and concerns surrounding the creation
of swap execution facilities.
I am Kevin McPartland, a principal and the director of
fixed income research at TABB Group. TABB Group is a strategic
research and advisory firm focused exclusively on the
institutional capital markets. Our clients span the entire
investment landscape including investment banks, pension plans,
mutual funds, hedge funds, high frequency traders, FCMs,
exchanges, and clearinghouses.
In order for this new market structure to be successful,
swap execution facilities must be given broad latitude in
defining and implementing their business models. This includes,
but is not limited to, the mechanisms used for trading and the
risk profiles of their members. This will promote the
innovation and competition that has made the U.S. capital
markets the envy of the world.
It is also critical that the mechanisms to move trades
quickly and easily from execution to clearing are well defined.
If market participants worry that the trade they have just
executed on a SEF might later in the day be canceled due to a
clearinghouse rejection, confidence in the entire market model
will erode quickly and severely limit the transparency and
systemic risk reduction the Dodd-Frank Act was intended to
improve.
Let us examine these points in detail.
First, SEFs should not be driven to a particular trading
model. Despite the inclusion of the Request for Quote model in
proposals from the CFTC and SEC, regulators are still keen to
have swaps trade through an order book with continuous two-
sided quotes.
TABB Group research shows that order book trading will
emerge naturally; 81 percent of our study participants believe
that we will have continuous order book trading of vanilla
interest rate swaps within 2 years of SEF rule implementation.
However, the existence of an electronic order book does not
guarantee liquidity nor that market participants will trade
there.
For example, of the roughly 300,000 contracts available for
trading in the highly electronic U.S. equity options market,
trading in only the top 100 names makes up nearly 70 percent of
the volume. The rest are seen as so illiquid that it is often
easier to trade OTC with a broker rather than try and execute
that same contract on the screen. Furthermore, despite the
market's electronic nature, TABB Group research shows that in
2010 as much as 97 percent of all options trading volume
generated by asset managers was done over the phone.
Second, we should encourage SEFs to set membership
requirements to encourage a variety of liquidity pools. The
U.S. equity market presents a good example. Thirteen registered
exchanges and another 55 alternative execution venues exist to
trade U.S. equities for a total of sixty-eight. Why are there
so many? Because different market participants trade in
different ways and have different needs. Some like to trade in
large size, some small; some are very concerned about price
while others are more concerned about getting a trade done
quickly. Because of this, the equity market responded with new
venues to meet those needs.
In the current swaps market, a smaller player cannot trade
in the interdealer market even if they had the capital and
desire. In the new market, as long as a trading firm meets the
requirements set forth by the SEF, they will be--and should
be--allowed in to trade. The important point to note is that
setting membership requirements for SEFs is not exclusionary,
but instead intended to help market participants trade in the
most suitable environment possible.
Open access to clearing will play a huge role in the
success or failure of all SEFs. It is central clearing, not the
SEF construct itself, that will allow easier access to trading
and new market participants to enter. But a clearinghouse
providing only the ability to accept SEF executed trades is not
enough.
SEFs are intent on providing click-to-trade functionality,
that when you accept a price on the screen with a click of the
mouse, whether in an order book or via a request for quote, the
trade is done. However, a trade is not done until it is
accepted for clearing--something the SEFs have little if any
control over. That raises the question: Can a SEF ensure a
trade will be accepted for clearing before it allows the trade
to execute? And even if it can, is that the SEF's
responsibility?
Either way, clearing certainty is crucial to the success of
SEFs. If market participants do not trust that SEF-executed
trades are firm, confidence in the entire market model will
erode quickly. It is critical that a mechanism be put in place
to formalize this process, ensuring the market can have full
faith in the trades they execute on a SEF.
There has been considerable speculation as to the number of
SEFs that will exist. The wildest number I have heard is 100,
which is simply unrealistic. If the U.S. equities market has 68
venues and the U.S. futures market has three main players, the
swaps market will fall somewhere in the middle.
Our research shows also that nearly 60 percent of market
participants believe the ideal number of SEFs per asset class
is three to four, resulting in 15 to 20 SEFs covering interest
rates, credit, FX, commodities, and equities. There will be
many more than that to start but not 100. Our list at TABB
Group shows as many as 40 firms that plan to apply. But 87
percent of our study participants believe that SEF
consolidation will begin 2 years or less from the date of rule
implementation.
We are now in the pre-SEF era. Business models and
technology are still being finalized, but most SEFs are
``registration-ready,'' and trade flow is beginning to pick up
on the screen as most everyone has accepted that these changes
are inevitable.
Even if trading mandates do not take effect until the
fourth quarter of 2012--a timeframe that seems more and more
realistic--the change is so enormous for most swaps traders
that getting started now should present just enough time to
make the switch.
As rules are finalized, it is critical that while putting
in place necessary oversight, new OTC derivatives rules
encourage the innovation and competition that have made the
U.S. capital markets the most envied in the world.
Thank you for your time.
Chairman Reed. Well, thank you very much for your
testimony.
Mr. Brady.
STATEMENT OF NEAL B. BRADY, CHIEF EXECUTIVE OFFICER, ERIS
EXCHANGE, LLC
Mr. Brady. Chairman Reed, Ranking Member Crapo, Members of
the Committee, thank you for the opportunity to testify on the
implementation of the Dodd-Frank Act, specifically the
development of SEFs. I am Neal Brady, chief executive officer
of Eris Exchange, LLC.
Eris Exchange is an electronic futures exchange that began
offering the trading of a cleared interest rate swap futures
contract in July 2010 in response to the passage of the Dodd-
Frank Act. Since its inception, Eris Exchange has traded over
$33 billion in notional value of its interest rate swap futures
which are cleared at the Chicago Mercantile Exchange.
Eris Exchange filed an application with the CFTC in April
of this year to be designated as a contract market, or DCM. A
DCM is a traditional exchange in which regulated futures
contracts have been trade for over 100 years. As a DCM Eris
Exchange will be permitted to list both financial futures as
well as swaps. As such, Eris Exchange will satisfy the Dodd-
Frank execution mandate and will operate alongside SEFs in the
cleared interest rate swaps base.
My opening comments are focused on the regulatory
incentives that can facilitate the successful development of
SEFs. I will also comment on a few arguments heard in the
industry recently related to perceived operational impediments
to SEFs and how these concerns have already been solved for in
the futures industry model.
First, Eris Exchange believes that the most important
regulatory incentive that the CFTC can provide for SEFs is to
announce clear dates for the implementation of the clearing and
trading mandates. The industry is ready to trade and clear
interest rate swaps. SEF-like platforms and DCMs are already
connected to the major clearinghouses and are operationally
ready to transact swaps and equivalent futures contracts. The
market is simply awaiting a clear timetable from the CFTC
before committing the resources for final implementation. As
soon as the timetable is announced, customers will select
preferred clearing firms and trading platforms, complete
documentation, and begin final testing.
In announcing a timetable, one of the most market-based and
competition-friendly actions that the CFTC can take is to
implement the trading mandate soon after the clearing mandate.
By mandating execution and ensuring open access to all clearing
venues, regulators will foster true competition in swaps and
create a level playing field for the emergence of new entrants
and technology-driven innovation.
If, on the other hand, there is a significant lag between
the clearing and trading mandates, incumbent firms will be
heavily motivated to direct clearing to their preferred
clearing venue and will transact on closed platforms dominated
by incumbent firms. Such a time lag runs the risk of severely
constraining the ability of new entrants to effectively compete
in the execution of cleared swaps.
Second, I would like to address a few arguments heard in
the industry today that are aimed at slowing down the
implementation of the Dodd-Frank Act. Specifically, concerns
have been raised that the documentation required for market
participants to exit and clear swaps is so extensive that it
will require untold hours of negotiation and impose burdensome
legal costs on customers. This is an exaggerated concern.
The futures documentation structure provides a model that
should be utilized as a baseline for documentation in the
cleared swaps market. In the futures model there is no need for
each user to enter into detailed ISDAs with every other user.
For example, to trade on Eris Exchange, a participant and a
participant's clearing firm need only enter into a single
agreement totaling two pages, one time.
Another argument heard today in the industry is that it is
impossible to trade interest rate swaps in an open, electronic
order book and, therefore, the traditional OTC execution model
must be maintained. Eris Exchange provides concrete evidence
that this argument is flawed. Today Eris Exchange has a live,
open, anonymous, electronic central limit order book offering
trading for standard maturities of interest rate swap futures.
Clearing firms guarantee each order and monitor risk using
credit controls that are built centrally into our trading
platform.
I have submitted a screen shot of the Eris Exchange central
limit order book, which shows live bids and offers on our
screen that are fully transactable and for which users receive
instant confirmations of cleared trades with the click of a
mouse.
In conclusion, it is worth noting that in the futures
industry the migration from pit-based trading to screening-
based trading unleashed a tremendous wave of innovation in
which the U.S. derivatives industry emerged as a world leader.
If regulators announce a clear timeline and apply the proper
incentives, the implementation of Dodd-Frank has the potential
to spur a similar technological revolution that will deliver on
the real benefits of the legislation, bringing greater
transparency and a wider variety of counterparties into the
swaps market and thereby reducing systemic risk.
Thank you for your invitation to testify here today. I look
forward to your questions.
Chairman Reed. Thank you, Mr. Brady.
Mr. Macdonald, please.
STATEMENT OF BEN MACDONALD, GLOBAL HEAD OF FIXED INCOME,
BLOOMBERG, L.P.
Mr. Macdonald. Good morning, Chairman Reed and Members of
the Subcommittee. It is a pleasure to appear before you today.
My name is Ben Macdonald, and I am the global head of fixed
income products for Bloomberg, L.P., a privately held company
based in New York. Bloomberg is dedicated to registering as
both a swaps execution facility and a security-based swaps
execution facility under Title VII of the Dodd-Frank Act.
Bloomberg's customer base is evenly distributed amongst the
buy side and the sell side. Therefore, as an independent
company, we are not beholden nor are we biased toward any
particular element of the market.
First of all, Bloomberg fully supports Title VII's
mandatory clearing and post-trade reporting requirements. Clear
and specific rules for those provisions will serve as the most
significant tools for reducing systemic risk and attaining
needed transparency for a reformed and financially sound
derivatives marketplace that benefits all participants.
As with all new regulations, however, the devil is in the
detail, and today we have concerns that these regulations will
be promulgated in a way that inhibits market trading
flexibility and raises the cost to the end user and, therefore,
does not fully achieve the goal set out by Dodd-Frank.
We know that the systemic risk threats that arose in 2008
and 2009 were associated with insufficient clearing and post-
trade price transparency and were not the result of execution
failures. Trading protocols were not the problem.
We believe that Federal regulators should not go to
extravagant lengths to define the most favorable terms of
execution for trading for what can only be characterized as a
market of sophisticated users. Rather, what should be incumbent
on Federal regulators is to ensure that the market is fair and
competitive and that participants themselves have enough
information to assess whether they know they got a fair price
or not.
One of the risks that Federal regulators run in
micromanaging execution protocols is that they would increase
the direct cost of trading with no real compensatory benefit to
customers. In addition, they would impose artificial
constraints and significant indirect costs that incentivize
market participants to revert to forms of trading that evade
the excessive regulation and its unnecessary costs. Ultimately,
the threat is that market participants will easily find
alternative ways to conduct their trading in non-SEF
environments, including taking their trading to foreign
jurisdictions where U.S. rules do not apply. Rather, we believe
that Federal regulators should instead use a principles-based
approach that encourages flexible trading protocols by SEFs.
Second, the difference in rules promulgated by the CFTC and
the SEC will create significant compliance costs. Though the
Dodd-Frank Act requires the two agencies to coordinate their
approaches, it remains to be seen whether they will
sufficiently do so in their respective final regulations. If
they do not, an entity designed to operate as both a SEF and a
security-based SEF will be compelled to create two separate
companies to trade similar instruments.
Please note that this affects each potential SEF and
security-based SEF but also their clients, many of whom
currently use the same individual traders to execute both
instruments. This barrier will drive a concentration in the
SEF/security-based SEF space and could create a too-big-to-fail
situation for the remaining SEFs in the marketplace, which is
exactly the opposite of what Congress intended when it enacted
Dodd-Frank.
It is our opinion that costs can be reduced by providing
the opportunity for SEFs to contract with third-party service
providers for market surveillance and discipline duty as long
as the SEFs meet the requirements within Dodd-Frank that they
retain full, ultimate responsibility for decision making
involving those functions. Practical, liberal utilization of
third-party service providers would enable SEFs to reduce their
capital and operational costs related to the infrastructure of
those functions and thereby reduce the cost of entry into the
SEF marketplace.
In addition, SEFs should also be permitted to rely on the
regulation and oversight performed by swaps clearinghouses
rather than have to replicate essentially the same activity at
the SEF level. For example, if a clearinghouse accepts a market
participant or a swap for clearing, the SEF should be permitted
to rely on that assessment for core principle compliance
purposes under the SEF regulatory regime.
In addition, the SEC's rules on governance and financial
reporting should be strictly linked to the requirements in
Dodd-Frank because extending the rules beyond the Act's
requirements effectively inhibits the entry of new security-
based SEFs. For example, an aspiring security-based SEF such as
Bloomberg, who is already independently owned and controlled,
could be discouraged if faced with SEC rules that would force
us to cede control of our affiliated SB-SEF to an independent
board. While SEC has suggested they may require this result, it
is not required by Dodd-Frank, nor is that a requirement
written into the CFTC's proposed regulations.
The goals of promoting competition among SEFs, lowering
barriers to entry, and allowing a consistent trading
environment demand that the two Federal regulators devise
coordinated rules and not work in silos. It is our hope that
Congress can assist in this process.
In summary, we are concerned that we may be on the road to
creating a too-big-to-fail and utility-style SEF landscape that
would increase costs for the end user, encourage non-SEF
trading, and ultimately reduce the benefits of central clearing
and price transparency.
Mr. Chairman, on behalf of Bloomberg, I want to thank you
for this opportunity to share our views on this important
issue, and I am happy to answer any questions that you may
have.
Chairman Reed. Thank you very much, Mr. Macdonald.
Mr. Cawley, please.
STATEMENT OF JAMES CAWLEY, CHIEF EXECUTIVE OFFICER, JAVELIN
CAPITAL MARKETS
Mr. Cawley. Chairman Reed, Ranking Member Crapo, and
Members of the Subcommittee, my name is James Cawley. I am
chief executive officer of Javelin Capital Markets, an
electronic execution venue of OTC derivatives that will
register as a SEF or swap execution facility--under the Dodd-
Frank Act.
I am also here today to represent the interests of the
Swaps & Derivatives Market Association, which is comprised of
several independent derivatives dealers and clearing brokers,
some of whom are the largest in the world. Thank you for
inviting me here today to testify.
Without a doubt, it is mission critical that central
clearing, increased transparency, and broader liquidity is
properly achieved under the act for the OTC derivative
marketplace. Toward that goal, it is important that SEFs be
allowed to properly function and compete with each other
whereby Congress and the regulators ensure that such
organizations and various execution models be neither
discriminated against nor penalized by trade work flow or
documentation efforts that show preference for one SEF over
another.
Only by access to a fair, level, and open playing field
will SEFs be properly able to play their part in the lessening
of systemic risk to which the derivative marketplace
contributed during the global financial crisis of 2008.
With regard to product eligibility, clearinghouses should
recognize that the fair majority of interest rate and credit
derivative products do qualify for clearing.
Regulators should be mindful to ensure that clearinghouses
do not favor acceptance of certain products that have built in
trade restrictions that impede open access or customer choice.
While intellectual property rights may protect innovation
in the short term, with regard to certain swap products or
indices, they may restrict trade and liquidity in the long run.
Market participants should be allowed to trade such products to
meet their investor or hedging objectives. Intellectual
property rights for such products should adapt with the post
Dodd-Frank marketplace where anonymous and transparent markets
flourish.
Regulators should work with such IP holders to both ensure
that their rights are properly protected but that the
prudential need of the broader market is also addressed.
With regard to SEF access to clearinghouses, clearinghouses
and their constituent clearing members should do as the act
requires--accept trades on an ``execution blind'' basis. DCOs
should not discriminate against trades simply because they or
they shareholders dislike the method in which such trades
occur.
Clearinghouses should refrain from using SEF sign-up
documentation as a vehicle through which to restrict trade. As
a precondition to access, clearinghouses should not require
that SEFs sign ``noncompete'' clauses, such that a
clearinghouse's other businesses--be they execution based or
not--are inappropriately protected from outside competition.
Likewise, clearing firms should not require that SEFs
contract with them to restrict the rights or privileges of end
users as a precondition to SEF-DCO connectivity. Such
requirements serve no prudential role with regard to risk
mitigation and run contrary to the open access provisions of
the act.
Clearinghouses should not require that a SEF purposely
engage in a trade work flow that adds latency or creates
unnecessary steps in the post-trade settlement process.
Instead, clearinghouses and their constituent clearing
firms should draw from their own proven and well-tested
experience in listed derivatives space. They should accept
trades symmetrically and in real time.
Immediate acceptance of swaps trades into clearing is
critical to accomplishing the goals of the Dodd-Frank Act to
reduce systemic risk, increase trade integrity, and promote
market stability.
Settlement uncertainty caused by time delays between the
point of trade execution and the point of trade acceptance into
clearing can destroy investor confidence in the cleared OTC
derivatives markets.
As the CFTC has correctly asserted, such a time delay or
trade latency, which in the bilateral swaps markets can be as
long as a week, directly constrains liquidity, financial
certainty, and increases risk.
Clearinghouses and their clearing members should do as the
regulators have required and accept trades into clearing
immediately upon execution on a SEF.
Regulators should be wary of certain incumbent efforts that
claim to bring execution certainty through documentation. Such
documentation sets in place work flow that clearly favors
Request for Quote execution models over exchange-like central
limit order books.
Such documentation denies the customer the right to trade
anonymously with multiple counterparties because under such a
work flow, the dealer counterparty requires the identity of the
customer be known before the trade occurs.
This is not the case with documentation and work flow
requirements in the cleared derivatives markets currently of
futures and options. In those markets, buyers and sellers trade
in multiple trade venues where trade integrity, counterparty
anonymity, and optimal liquidity is assured through access to
multiple counterparties.
Such restrictive work flow and documentation should be seen
for what it is--nothing more than a transparent attempt to
limit customer choice, restrict trade, and drain liquidity.
In conclusion, the role of the swap execution facility with
regard to lessening systemic risk should not be understated. To
fulfill the SEF's role in fostering greater liquidity and
transparency, Congress and the regulators should continue to be
proactive and protect the market against Dodd-Frank
implementation choke points. They should continue to ensure
that all SEFs have fair and open access to clearing and the
marketplace.
I thank you for your time, and I am open to any questions.
Chairman Reed. Thank you very much, gentlemen, for your
very thoughtful testimony.
Let me just sort of lay out the logistics. We have a vote
at 11, and we have another panel. I would propose 7-minute
rounds, and I know we are not going to be able to ask all the
questions we want to ask, so be prepared for additional
questions following up the hearing. But let me begin again by
thanking you for your insightful testimony.
I will address a question to the whole panel, and it has
been touched upon. Specifically, in response to the CFTC's
Notice of Comment, the Justice Department Antitrust Division
raised some concerns about their proposed rules with respect to
the ability of major dealers to control access to the markets
unless there is--and the SEFs, unless there are some ownership
limits, aggregate ownership limits or individual ownership
limits, together with governance issues. I know you all have
talked about it, but the goal I think we all share is to
maximize competition while at the same time limiting barriers
to entry into these platforms and into these processes.
So if you might elaborate, starting with Mr. McPartland and
down to Mr. Cawley.
Mr. McPartland. It is important that we still have the
major dealers involved actively. This is their market. If we
talk in other areas of finance, we talk about having skin in
the game. The last thing is we want are some of the biggest
traders in these products not actively involved and invested in
the success of these entities.
I think the language of Dodd-Frank and some of the proposed
rules will ensure that we will still have open access. The
access to clearing is really what will open these markets up,
because it takes out a good amount of the counterparty risk,
whereas now in the bilateral world, a dealer could quite
rightly choose to not trade with a counterparty if they felt
their credit was not up to war. The clearinghouse helps to
mitigate those concerns.
But the short answer here is we need the dealers still
involved. This is not about pushing them out. It is about
keeping them in the position they are in and then opening up
the market to more competition beyond that.
Chairman Reed. Mr. Brady.
Mr. Brady. Yes. At Eris Exchange, we do not think research
and ownership are going to do everything. The people most
likely to actually be new entrants and provide a credible
alternative and increase competition in the space are precisely
those people like the founders of our exchange who are in the
market and are able to drive forward with a platform like this.
We think the focus instead should be on the issues like open
access, real time trade acceptance, making sure the SEFs and
the clearinghouses are open and available for people to trade
on.
Chairman Reed. But just to follow up, so your notion is
ownership is not the issue, open access. So the rules that SEC
and CFTC have to come up with have to really provide an
incentive for broad-based participation and prevent, regardless
of ownership, so favoring one entity--I think I am restating
what you said.
Mr. Brady. Yes. I mean, that is absolutely vital, to allow
anyone who is qualified and fulfills certain requirements to
have access to a cleared product and access on a SEF, whether
the owner of that platform, yes, I think that is less
relevant----
Chairman Reed. One of the issues that has come up in the
context of the presence sort of an ad hoc system is the
requirements for capital to participate are being set by the
big players, basically----
Mr. Brady. Yes.
Chairman Reed. ----and there is at least some suggestion
that these requirements are not necessary the market to
function----
Mr. Brady. Right.
Chairman Reed. ----but they are quite conducive to
continued dominance.
Mr. Brady. Right.
Chairman Reed. Do you have any comments?
Mr. Brady. Yes. In our view at Eris Exchange and the
partners that I represent, that is a much more critical issue
than the actual ownership. It is the researchers on clearing or
membership to clearing ought to be based on risk-based criteria
and who can step in in the case of a default. In the case of
the futures industry, the people who took care of the Lehman
bankruptcy, for example, it was an open auction. A number of
the players who actually ended up picking up the portfolio were
not clearing members or non-clearing members. It was like a
market-based solution, and criteria like that are much more
important than ownership restrictions.
Chairman Reed. Let me go to Mr. Macdonald and Mr. Cawley.
Mr. Macdonald, please.
Mr. Macdonald. Yes. I think this is a quite interesting
question. From our perspective, we already are an independent
company, so it is kind of disincentivizing, if you will, from a
commercial perspective, to try and build a business in the SEF
space that is competitive and then have to concede control of
the board of that SEF. It does not really make sense. We
understand and we recognize the need for governance and
independence and we think that is a good thing. However, we
also think there needs to be a mechanism for companies such as
ourselves and other companies who are already independent to
operate in this space without being penalized for being
independent, and I think that goes to the crux of our issue.
I do think there is one other point which kind of touches
on what Neal was saying, which is that SEFs have different
models. In some cases, they take on principal risk because of
the nature of their business and in some cases they do not, and
I think, again, when we look at capital requirements, we need
to make sure that they are commensurate with the style of SEF
that we are talking about, because there clearly is not a one-
size-fits-all in the SEF landscape, and there should not be.
Chairman Reed. I can presume, though, that you would not
object to a certain number of independent directors, for
example, in the governance of these----
Mr. Macdonald. No, no----
Chairman Reed. ----the control issue.
Mr. Macdonald. No, and we understand and we totally--I
mean, we think it is a very good idea. We just think that there
is a practical limit which kind of, you know, goes a little bit
too far.
Chairman Reed. Mr. Cawley, please.
Mr. Cawley. We think that whenever the dramatic change in
market structure such that we are currently undergoing as a
result of the crisis in 2008, one has to--the Government and
regulators really should monitor and engage when necessary
whenever you--when you have a marketplace moving from the haves
to the have-nots. So whereas the old market in the bilateral
space had ten or 15 dealers, I do not think anyone is trying to
exclude them from the future. I think it is more a function of
including another 25 or 30 dealers and broadening the
competitive range.
And as you go and experience that change, it is important
that any governance structure, whether it be at a DCO or
clearinghouse or, indeed, at a SEF, have a fair degree of
transparency and a fair degree of market participation on
material committees that address the prudential issues
concerning these organizations. It is not enough to come in and
say, look, shareholders have a right, or the management have
the right to enhance shareholder value. That is clear.
But SEFs, and more specifically DCOs, share a broader
prudential need to the marketplace and in so doing need to
address that and have open governance, which you can separate
from economic interest. We just ask that it be open,
transparent, and be truly representative of the marketplace,
not only in terms of dealers, but also in terms of clearing
members and also market participants and end users.
Chairman Reed. Thank you all, gentlemen.
Senator Crapo.
Senator Crapo. Thank you very much, Mr. Chairman, and in
light of the time restraint we have, I am going to ask just one
question and then try to give each of you an opportunity to
comment on it, if you would like, so I encourage you also to be
concise in your responses.
My question relates to the fact that the end users have
expressed concern to me that many of their large or less liquid
transactions may not fit within the definition of a block trade
that is being proposed because of its limited nature, and they
are concerned also with things like the requirement to bid
trades to no fewer than five market participants or the delay
built in in terms of the processing of blocked trades, and
these things may create a dynamic in the market that will then
drive up the cost of operations.
I would like to know--my question is, do you agree with
these concerns, and if so, what can we do to address them?
Mr. Cawley. If I can--Kevin, do you want to go first, or--I
think if you look at block trades, you have to consider the
tension, Senator, on both sides. Whereas on one side there is
the market need for transparency, the most important aspect or
the most important information that any trader or any market
participant can have is where the last trade occurred, at what
price and at what time, and to go into a marketplace and not
know that is putting that individual or that entity at a
disadvantage.
So on one side, the customer has the right to know, or
should have the right to know, consistent with other markets,
where the last trade occurred. But then on the other side,
large dealers and large participants are less incented to
create liquidity for block trades.
So it really falls down, if you look to other markets, A,
what should the size of a block trade be, and what should there
be a delay, how long that delay should be such that the market
maker has the opportunity to hedge their risk on such a block
trade. If that time period is too short, then the market maker
is loathe to make a market in such size. If it is too long,
then the end user is disadvantaged.
The way we have suggested you consider that is to look to
other markets, especially in the interest rate futures swap
context--or in the interest rate futures context, and set a
rate or a block size notional that is consistent with those
markets and also a timeframe that is consistent with those
other markets, as well, as a base from which to go.
Senator Crapo. Thank you.
Mr. McPartland, did you want to comment?
Mr. McPartland. Sure. Information leakage is a big concern
for all end users and by said market participants, and if we
look at the swaps market, the size of the transactions and the
infrequency that many of these contracts are traded makes it
even more of a concern, and I think that echoes some of Jamie's
points. This is why--and again, it is sort of a parallel in the
equities world--this is why crossing networks developed, for
example. Buy-side firms that needed to do large-side trades had
a hard time doing that in the open market, so they found a new
mechanism.
It goes back to my earlier comments that if we provide or
allow latitude for SEFs to create market models that suit
different market participants, we could end up with an
environment that is suitable to doing those large-side trades.
If we do not allow for that type of environment, you could
force end users to look to more liquid products that they would
have to do in smaller size to get their large size done. It
could result in an imperfect hedge. An imperfect hedge then
means more risk rather than less risk for those end users.
Senator Crapo. Thank you.
Mr. Brady.
Mr. Brady. Yes. We think this issue, it is a very important
issue and we think it is an issue that really highlights the
need for a principles-based approach to regulation because the
issues are very interrelated, whether you should require five
counterparties to be pinged on a request for quote and the
block trade limit. If you set the block trade threshold
correctly, you could have a stricter requirement to send the
RFQ because if you believe in larger size, you have the
flexibility to do the blocks. But every market is different.
Standardized products are different than very bespoke products,
and I think the futures industry is a great example of how this
works. There are block trades allowed. They are set at a
certain threshold that is principles-based and large size is
able to be transacted when needed, but then the rest of the
trades occur either in the central order book or through a very
wide open request for quote process.
Senator Crapo. Thank you.
Mr. Macdonald.
Mr. Macdonald. I would echo all of the points that have
been made. I think the key point here is actually that the end
user needs to have the flexibility of means of execution. I
think for the same trade, the ability to get executed or get
liquidity will vary depending on a given set of market
circumstances. So it is very hard to put down a set of very
defined rules and think that they will work in every
circumstance. They will not. And I do think that the market
will, as long as it is a principle-based approach and as long
as there are guidelines around execution to manage that
process, I think the market will, as Kevin pointed out, reach a
medium where it provides the necessary means of execution for
different circumstances.
Senator Crapo. Thank you. I will yield back a couple
minutes to you, Mr. Chairman.
Chairman Reed. Senator, thank you very much.
Senator Merkley, please.
Senator Merkley. Thank you, Mr. Chair, and thank you to all
of you for your testimony.
I wanted to start, Mr. Brady, with your comments about the
value of setting effective dates, for the CFTC to set clear
dates for both trading and clearing, and I thought maybe I
would just give you a chance to, if you wanted to advise the
CFTC, what dates should be recommending that they set and why.
Mr. Brady. Yes. I mean, the general point that we would
like to stress is we believe the marketplace is ready. I mean,
you have examples of platforms and swap execution facilities
that are ready and operational today, connected back to
clearinghouses. In our view, the market is really looking for a
clear signal to focus around and then motivate people to make
decisions, commit resources, and a lot of the issues we are
discussing today in the industry really can be settled with
people who are highly motivated and with a deadline to reach a
lot of sort of the documentation issues, the credit control
issues, these sorts of issues.
We have put forth in various comment letters a timeframe
that talks about completing all the final rules through the end
of this year, allowing provisional registration of SEFs so we
do not slow down that process, you know, beginning with some
clear mandates starting first quarter, second quarter of next
year, starting with the most sophisticated users, mandates on
those users and then moving in sort of a sequenced process
through the less sophisticated people who have more operational
issues. So we think that is the type of time table. If it were
laid out clearly from the regulators, you would see a
tremendous amount of focus and innovation and sort of work
toward achieving those goals.
Senator Merkley. And do you picture between the
sophisticated users and the balance of the marketplace a 3-
month transition, a 6-month transition, a year transition?
Mr. Brady. Yes. I mean, I think that is--we do not have a
specific recommendation, but we think sort of quarterly rolling
in different layers of participants would make some sense.
Senator Merkley. So let us say the initial deadline on
trading was, say, March 2012. Do you picture the clearing date
being the same date, or a difference there?
Mr. Brady. You know, I think--we think some type of lag
between those two would make some sense operationally, but not
a significant one. So lagging it by a couple of months or a
quarter could make some sense. We also think allowing for some
voluntary compliance, maybe the first quarter of 2012 includes
voluntary compliance with the clearing mandate. People work out
the plumbing and test rates would certainly seem to make a lot
of sense.
Senator Merkley. Does anybody have a radically different
opinion they want to share on this?
So I wanted to turn, second, to a point a couple of you
mentioned, which was a separation of the trading and clearing
dates and the lack of confidence if your trade is not a trade
until it is cleared at some future point. It is my
understanding in the commodities market that these are done
simultaneously. What is driving that separation and how long of
a time lag are we talking about, and is it a startup problem to
have those things happen simultaneously or some type of long-
term structural philosophical fight going on here?
Mr. Brady. If I could, maybe I will just start by talking
about how it works in the futures model----
Senator Merkley. Great.
Mr. Brady. ----and then hand it over to the other
participants here. I mean, the futures model, the essence of it
is that there is a pretrade credit check. So, for example, in
the Eris exchange platform, there are credit controls on the
platforms and if you see a bid or an offer for a 200-million
size 5-year swap quote, that has been preapproved and there is
a clearing firm standing behind that quote. In addition, when
you submit a block trade, we have credit controls at the
clearinghouse, I mean, on entry to the clearinghouse. So either
the trade is submitted and it is good or the trade never
existed. It is rejected for credit.
The SEF model, and I will let the others comment on that,
today, we are working through those issues where the SEF is not
directly connected to the clearinghouse, and I will let others
comment on how that is being worked out.
Senator Merkley. OK.
Mr. Cawley. So on its face, Neal is correct, Senator. Real-
time acceptance of trades in the futures context works and has
worked well for many years, whether it be on an exchange or in
the clear port example with CME in a more decentralized basis.
That is something that the CFTC and regulators have called for
with suggested rules for the OTC space and we do not see from
where we sit a problem with that. The MFA has also come out in
support of, as has the STMA, come out in support of real-time
acceptance of clearing.
And if you think about it, it is really mission critical to
the success of clearing because it really comes down to the
fundamental integrity of the marketplace. Whereas in the
bilateral market space, trades would go unsettled a few years
ago, even for as many as 3 or 4 years, now, that window is down
to a few days or a week. But that is still, relative to other
markets, quite a long time. So it creates an uncertainty
between the SEF and the DCO and ultimately it ends up with a
customer having lost faith in the marketplace. So the
technology is there now to use and is available and people are
working toward these.
Senator Merkley. So I want to back up and see if I heard
you correctly. You say that commodity trades in the near past
sometimes were unsettled for 3 or 4 years?
Mr. Cawley. CDS trades, certainly, yes. Back in 2003 to
2004, there were many trades that have been unsettled. Some
trades have actually gone--had matured before they had settled.
Senator Merkley. Hmm. OK.
Mr. McPartland. So one of the big differences between the
futures market and the new sort of SEF cleared swaps
environment, in the futures market, you have one exchange
feeding one clearinghouse. In the swaps environment going
forward, we are going to have many execution venues feeding
many clearinghouses. So that makes ensuring that the execution
venues and the clearinghouses all have the most up-to-date
information a much more complex process.
Now, to Jamie's point, the technology certainly exists to
allow that. There are a few thoughts about how this would work.
Some think that we should have a central utility that will look
at all of the limits and the client accounts at the
clearinghouse and hold that and feed that information out to
all the SEFs and clearinghouses. There is also a thought that
the clearinghouses, since it is about the clearing account,
that they will hold the information and when they get a new
trade they will broadcast that out to all the relevant SEFs and
the other clearinghouses.
Many of the dealers, though, are concerned that they do not
want to have to give up essentially their risk models that they
use to determine how much a client can trade to an outside
party. So many of the big dealers would rather--as they say, we
will tell you when to stop a certain client from trading. We
will let you know.
So, again, as Jamie said, the technology is certainly
there, but I think it is more of an operational concern than it
is a technology concern.
Senator Merkley. All right. Thank you very much.
Chairman Reed. Thank you, Senator Merkley.
Senator Corker, please.
Senator Corker. Thank you, Mr. Chairman, and I thank each
of you for your testimony, and for what it is worth, I thought
your answer to Senator Crapo's question, considering that each
of you sort of benefit from these new regulations, was pretty
judicious, and I thank you for that and for being forthcoming
in that regard.
I would ask this question. Back home in Tennessee, people
are saying, you know, we wish that you guys would quit helping
us the way that you are in Washington. Who is it that we are
actually helping with the creation of these SEFs? You know, we
met with some of the big traders Monday and the big market
makers obviously are not being helped by this in any way. So
who is it that we are helping?
Mr. Brady. I would be happy to start with that. If
implemented correctly--you know, it is a big if--we believe
principles-based is the way to go. But if implemented
correctly, we believe the ultimate end users, the asset
managers, the people who are the end users of swaps products
would have more transparency if these systems were able to
connect correctly, there were real-time trade acceptance, and
you had price feeds on which you could rely for transactable
swap prices.
Senator Corker. So, I mean, I thought you all, again,
judiciously answered the question, but when you have got a
large block trade and you are used to dealing--your client, a
BlackRock or a PIMCO, is used to dealing with a certain dealer
and they want to unload a position and they are willing to take
it, it does seem that this is a problem as it relates to people
being able to front run, if they have got to report too
quickly. I mean, that is a heck of a problem, is it not?
Mr. Brady. Yes, and that is why it is absolutely critical
to get that block trade threshold right. And again, just to
point to the futures market, the BlackRocks, the PIMCOs, those
players are very active participants in the futures market and
they use the transparent order book, and then when they need
to----
Senator Corker. Yes, but futures are a little bit
different. That is a little bit more of a plain vanilla market
than can happen with swaps, is that not correct?
Mr. Brady. Well, there are a number of standardized vanilla
swaps that are actually very like futures. I mean, that is the
issue of for standardized swaps. That is generally what we are
talking about trading in a central limit order book or----
Senator Corker. So let me ask you this question. So let us
say that you are involved in a large trade and you are creating
liquidity for a client, and right now, I know the CFTC is
talking about reporting in 15 minutes. It is pretty hard to
unload a big book in 15 minutes. What is--why not end of day
reporting? Why have a 15-minute reporting guideline?
Mr. Brady. I mean, again, I think that is our position on
that and the partners in our exchange would be that is where
principles-based regulation is important----
Senator Corker. So end of day would be fine on the large--
--
Mr. Brady. I think it depends on the marketplace. I think
every market is different. Different swaps require different
treatment.
Mr. Cawley. Senator----
Senator Corker. I would love to have some other input here.
It sounds like you all are actually in agreement that 15
minutes is way too short.
Mr. Cawley. Well, it really--we are not in agreement with
that, Senator. I think 15 minutes for the futures market is
pretty consistent with the liquidity that is offered within the
interest rate swap market and certainly indices, which is 40
percent of the credit derivatives market. Fifteen minutes by
certain market participants is viewed as too long.
I think it really comes back to Neal's point, which is it
is specific to the liquidity in a particular marketplace. If
you look to the futures world or the exchanges today, it is 15
minutes. At some point, it was an hour, and at some point, it
was end of day when the markets were less liquid.
So the key thing, then, is to measure the amount of
liquidity within the marketplace that allows that market maker
the opportunity to trade out of that position and to hedge it
appropriately. And when you are talking about 2-year interest
rate swaps that their average ticket size is $400 million at a
clip, that is pretty good liquidity.
Senator Corker. So it is kind of interesting, do you not
agree, that on one hand, we have castigated the heck out of
high-frequency trading in equities and yet we are moving toward
sort of algorithm-type trading on the swap side. I mean, is
that an interesting----
Mr. McPartland. Yes. Well, I can comment on that, Senator.
Senator Corker. OK.
Mr. McPartland. So the alternative, if the block trading
rules are too onerous and the market sees that that will create
too much information leakage, the alternative will be to then
take your $400 million and use an algorithm to split it up
into----
Senator Corker. Right.
Mr. McPartland. ----400 trades and spread it all across a
variety of SEFs, which is exactly what happened in the equities
market and I think some feel that that has made the equities
market more liquid, but others feel that it has made it much
more complex to understand who is doing what and what is going
on.
Senator Corker. But you would agree that we sort of have a
bipolar way of thinking here. On one hand, we want to move away
from that on equities, but on the other hand, we are driving
toward that in swaps.
Mr. McPartland. There is no question, and I am in the
process of research now where we have been talking to a number
of the proprietary trading firms about this issue. Now, let us
remember that in equities, as well, they provide a lot of
liquidity to the market and then it also brings--ensures that
prices are much more in line. So futures prices, swaps prices,
everything will line up much more closely than it does today,
and that should ultimately result in better prices for the end
user who needs to do an interest rate swap to hedge their loan
book.
Senator Corker. So we actually watched--I watched one
occur. It is not that interesting, actually. But we watched
this occur a little bit on Monday, and it is kind of, like, if
I am a client and I have been used to dealing with X dealer and
now I have got to get five bids, if you will, that just seems
ridiculous to me. I mean, if I want to--if you look at the
spread difference, it is very, very minor in these trades. Is
that not onerous to make a client that does this on a daily
basis have to get five bids? Is that not just ridiculous?
Mr. Macdonald. Senator, I think what we are really talking
about here--we keep on going back to the point of flexibility.
The reality is that in any given set of circumstances----
Senator Corker. But the CFTC is not acting as if they are
giving flexibility. They are talking 15 minutes and five bids.
So you are saying that is wrong, is that correct?
Mr. Macdonald. Our thought currently is that it is very
hard. Two things will likely happen if you are prescriptive
about exactly what RFQ needs to do and about reporting
deadlines. As the market evolves and liquidity changes, people
may not actually be able to get execution or may not actually
want to go out to that level of market players for their own
shareholders' reasons and dispute what we thought we are
actually creating--we actually may be creating more risk by
being prescriptive about protocols versus having a principles-
based approach which gives people a framework to operate and
gives them the flexibility to adapt to their business models.
Senator Corker. And just--I know my time is up--a lot of
concern about folks with these new rules that we are putting in
place with developing markets going elsewhere, not sort of the
industrialized countries, but Latin America and other places,
living, having to live by our rules, will go outside of the
U.S. to execute. Do you all not have similar concerns based on,
again, what CFTC and others have laid out thus far?
Mr. Macdonald. Well, I think, clearly, we operate in a very
global market and a lot of entities are--there are a lot of
U.S.-based entities, but there are also a lot of other regional
entities, and I think that insofar as we create difference in
regulation, although it exists, different regulation regimes, I
think at the end of the day, entities will go to wherever they
feel the regime is most appropriate for their activities.
Senator Corker. So the answer is yes.
Mr. Macdonald. Yes.
Senator Corker. So, Mr. Chairman, this has been a great
hearing. I do hope, maybe--in listening to the testimony, these
guys all benefit from what we are doing, I mean, and I am glad
they are here. They are going to make a lot of money off what
we have done and I am glad they are. But they themselves are
talking about some of the frailties and maybe there is
something we might do together letter-writing-wise to CFTC to
make sure that what they do is not so rigid and prescriptive
that we actually have unintended consequences. I thank you for
the hearing and thank you for the time.
Chairman Reed. Thank you, Senator Corker. And just let me
return to the point that Senator Crapo made, which is the idea
of coordinating as much as we can imagine, a unified set of
rules that apply to the SEC-regulated entities, which is our
jurisdiction, and the CFTC entities, which is the jurisdiction
of the Agriculture Committee, but I think one strong message
that you want to send today based on this testimony and based
on Senator Corker's comments is a notion of sensible unified
rules that our industries can profit by, and not only
industries, but the end users and the community at large.
I think one of the points, and raise your hand if I am way
off base, but we have seen in equity trading, because of the
efficiencies brought to the market, that the spreads have come
down considerably with the benefit of people who buy and sell
stocks every day, and that is a lot of people, pension funds,
all sorts of folks. And I think my sense is, based on your
testimony, we will see the same thing if we get this right in
terms of the swaps market, and that would be useful to the
whole economy, a more efficient economy. But I think, Senator
Corker, we certainly hope that our colleagues across the way in
CFTC and SEC pay close attention to what is said today, and we
can follow up with them.
Senator Hagan, you have arrived. We have a panel. Your
questions.
Senator Hagan. Yes. Thank you, Mr. Chairman. I appreciate
that.
Mr. Macdonald, in your testimony, you state that Bloomberg
intends to be prepared to begin swap execution facility
operations on the implementation of regulations by the CFTC and
the SEC, provided that the two regulators create synchronized
rules governing trading protocols, board composition, and
financial reporting. Would you like to comment quickly on how
that synchronization is progressing, and also, I would like to
ask, why are trading protocols, board composition, and
financial reporting important to your ability to begin
operations, and can you address each one individually?
Mr. Macdonald. Sure. So from our perspective, we are ready
to operate as both a swaps execution facility and a security-
based execution facility. I cannot talk specifically to the
cooperation between the CFTC and the SEC because obviously I
spend most of my time in New York. That said, when we look at
the facts as we know them today, there are a couple of areas
that raise some concern for us when we look at becoming both a
swaps execution facility and a security-based execution
facility, namely the one that we will have to actually create
two companies that have different board requirements in order
to operate in markets that are very similar in terms of the end
user base. So our concerns are really more around--and I will
address, first of all, the governance and the independence, and
then I will address the trading protocols.
From a governance and independence perspective, we
understand and we recognize the need for independence in both
the kind of the company structure and the governance around the
swaps execution facility for obvious reasons. Our point is that
we are already an independent company, so forcing us to put
independence on top of independence does not really make sense
from both a commercial and a structural perspective, and that
is one of the things we are looking at. We know that the CFTC
has slightly different rules in that regard than the SEC. The
SEC requires a majority of the board to be independent, whereas
the CFTC only requires 35 percent.
When we talk about trading protocols, our point is really
that of our customers. We are, as an institution, just an
intermediary between buyers and sellers, and our view from a
very long experience in this market is that it is very hard to
have a one-size-fits-all when you talk about RFQ or, indeed,
any trading protocol, and there are two main reasons for that.
First, if you define a specific protocol, the issue that
you will face is that as the market evolves and the liquidity
does change in these markets, that protocol may become
inappropriate and actually increase more risk in a given set of
market circumstances than it would reduce risk.
The other point that we would make is that by not using a
principles-based approach and by being prescriptive about the
types of protocols, what happens is that it will make the
market less competitive and more utility style because people
will not be able to innovate because they are constrained in
terms of what they can do as a SEF. So those would be the
points we would make.
Senator Hagan. Thank you.
Let me ask also Mr. Macdonald, also in your testimony you
noted that elaborate execution protocols will increase the
direct cost of trading and could drive business off of the swap
execution facilities or, what I would hate to see, into foreign
jurisdictions. How would you judge the proposed rules that are
coming out of the CFTC and the SEC against this standard?
Mr. Macdonald. Well, you know, we think--and, you know,
when I talk about an RFQ, a minimum of five or in the SEC's
case an RFQ with resting orders for the winning bid. I think
the issue with these is really what will happen is they can
create direct costs for a number of reasons, firstly, because
of this element of what people call the winner's curse, i.e.,
the fact that I know that I have got four other people in
competition with me on that trade means that people are not
necessarily in every circumstance going to want to show the
best price as possible because the result of four people
knowing that that trade got executed in the market means when
the entity that did win the trade has to turn around and go and
hedge that out, then there are four people in the market who
know that that hedge activity is about to happen in the
interdealer market, and that will have an impact on price and,
therefore, a direct impact on the end user.
Another point which is perhaps a little bit less obvious is
that what may happen in order to mitigate that risk is the
execution size will get reduced, and so people will actually
execute in smaller sizes in order for that kind of winner's
curse or information not to be as apparent in the market. What
that has is a direct operational cost on the end user, so I
will give you an example. If I am a fund manager and I have to
do an allocation on a trade, so I may want to do a block trade
for, let us say, 100 million and want to allocate that out to
50 funds, if I go out and I actually have to--instead of just
doing one trade and one set of allocations, I actually have to
go out and do five trades to reduce the size. I now have to do
250 allocations, which significantly raises the cost on me as
an end user in terms of processing that trade.
So that is what we mean by raising the direct cost.
Senator Hagan. And how about the threat of sending those
offshore?
Mr. Macdonald. Well, I think it is clear, you know, that
this is a global market, and I think when we look at the
regulatory proposals that we see in the U.S. versus what we see
in Europe and other jurisdictions, the risk that we highlight
is one where different regions have different regulations, and
then, you know, companies that are not subject to U.S. rules
will make the decision as to whether they want to operate
inside the U.S. or outside the U.S. for trading activity. And,
you know, that I think is a valid risk.
Senator Hagan. Thank you.
Mr. McPartland, you raised what I think is an important
issue, and with the proliferation of SEFs and clearinghouses,
how will credit risk be managed across entities? And do you see
this as a potential source of systemic risk?
Mr. McPartland. The technology certainly exists to manage
the problems, but operationally it is very, very complicated
when we have a number of different entities with different
needs and different end games. We should not try to regulate
how this should work; however, the industry needs to come to
some consensus as to how these issues will be resolved before
the market can move forward effectively.
The faith in a SEF execution is very much based on the
industry's knowledge that it will be accepted for clearing, and
that goes to the point of ensuring that the interconnectivity
between the SEFs, the clearinghouses, the swap data
repositories is all very well defined and available to the
market participants.
Senator Hagan. And how will the industry come together to
make these decisions?
Mr. McPartland. Well, the industry has been working
together for the last few years obviously on many of these
issues through the industry bodies. It is in everybody's best
interest to ensure that this does work. The changes are coming.
So, you know, to that, the more efficient that the process can
be, the easier it will be for everybody to modify their
strategies and their business approach to work in the new
environment.
Senator Hagan. Thank you, Mr. Chairman.
Chairman Reed. Thank you very much.
Please, Senator Toomey.
Senator Toomey. Thank you very much, Mr. Chairman.
I just have one quick question for any of the panelists who
would like to respond to it. That is, the fact that the SEC and
the CFTC have different rules, rules that are--especially with
respect to, for instance, the number of dealers who would have
to quote on a price, the timing that would be required to
intervene before the disclosure of block trades, frankly it
does not make a lot of sense to me. I understand they regulate
slightly different kinds of contracts, but at the end of the
day, is it your view that we ought to harmonize this and we
ought to have the same requirements between the CFTC and the
SEC?
Mr. Cawley. Well, Senator, let me attempt to answer that.
The SEC regulates credit derivatives, and the CFTC regulates
interest rate swaps and indices. And I think when you consider
those three different swap classes, there are different
liquidity considerations in each. So consequently there should
be different block size of block trade reporting requirements
in terms of size and also in terms of time. So it is certainly
consistent that they would have different views for each
particular class, especially when you look to other asset
classes where similar rules exist, but be it in futures or
options or even in the equity markets.
With regard to your concern vis-a-vis RFQ and the potential
limitations that that may have on liquidity, whereas on the one
hand a customer is loath to put their name, size, and direction
out on a particular trade to multiple counterparties, one also
has to measure it against the tension by giving it out to too
few. One of the suggestions from the SEC, for example, has
required that an RFQ go out to one entity. We think that that
is fraught with danger from a market manipulation standpoint,
and we should protect against that.
Our customers certainly have the ability to go out to five
or three or whatever the number is. I do not think they are
looking to go out to see 10 or 15 or 20.
Under those certain rules, they do not necessarily have to
show their name in addition to size and direction. They can
initiate what are known as ``anonymous RFQs,'' and they can
certainly access the central limit order book or the exchange
marketplace as well so they can avoid the RFQ requirement
altogether. So there are certainly many avenues for customers
to come in and trade.
Senator Toomey. Mr. McPartland, I wonder if you have a
different perspective on this.
Mr. McPartland. I think Jamie raises some very valid
points. The credit market, the rates market are very different.
They have very different users, very different uses for those
products.
However, I would suggest that the regulations should be
considerably more harmonized than they are, and it would be
left then to the SEFs and the market participants to ensure
that the SEFs that are focused on trading credit derivatives
are designed in such a way that it helps liquidity in those
markets, and the same for the interest rate markets. So rather
than regulatory differences, we would have differences in
business models in the SEFs that are trading in those products.
Senator Toomey. Mr. Brady, anything you would care to add?
Mr. Brady. I think we are returning to the theme, a number
of us, of urging the regulators to take a principles-based
approach. Certainly more harmonization between the CFTC and SEC
is welcome. But I think we also recognize that markets are
different, and both agencies should strive to take a
principles-based approach.
Senator Toomey. Thank you.
Mr. Macdonald.
Mr. Macdonald. Sure. I think there are broadly three things
here. The first is that as it pertains to block sizes and trade
reporting requirements, I think clearly there are nuances
between each element in these markets, and whatever the end
regulations will be should be reflective of that.
I think when we talk about execution protocols, you know, I
would echo what Neal said, which is that it needs to be a
principles-based approach. I think it is important to note that
there is quite a strong correlation between the single-name
space, which would be regulated by the SEC, and the index
space, which would be regulated by the CFTC, and, therefore, it
is important that users have a similar experience on executing
on both of those platforms.
The last point I would like to make is really the one about
governance within thesecurities-based SEF space. I think it is
clear that the population and size of the market that will be
regulated by the SEC is much smaller than the one which is
going to be regulated by the CFTC. And I think that if the
barriers to entry to the SB-SEF space and the governance rules
that will be put in place by the SEC are prohibitive, I think
what you may end up having is a mismatch between the platforms
that operate in the index and swap space versus the platforms
that operate in the single-name space, because it may not be
commercially viable for somebody to build an entity or a
company to operate in the SEC space.
Senator Toomey. Thanks, Mr. Chairman.
Chairman Reed. Thank you, Senator.
Thank you, gentlemen for your excellent testimony, and I
will ask the next panel to come forward. Thank you.
[Pause.]
Chairman Reed. I would like to recognize my colleague,
Senator Toomey, to introduce Mr. Thum. Senator.
Senator Toomey. Thank you very much, Chairman Reed, for
giving me this opportunity to introduce Mr. William Thum, a
principal of the Vanguard Group in Valley Forge, Pennsylvania.
Vanguard is, of course, one of the world's largest investment
management companies, employing over 12,000 people in the
United States and abroad. Mr. Thum is currently the senior
derivatives transactional and regulatory specialist in
Vanguard's Legal Department. Try saying that five times fast.
Prior to joining Vanguard in 2010, Mr. Thum was a partner
with Fried Frank Harris Shriver & Jacobson, LLP. From 1998 to
2007 he was an executive director and head of institutional
securities documentation for the Americas at Morgan Stanley.
From 1996 to 1998 Mr. Thum was a vice president and head of
derivatives documentation at UBS. He also worked at BNP Paribas
in New York and at Dresdner Klein Ward in London as legal
counsel. Mr. Thum has been an active contributor to industry
efforts to develop market standard documents for derivatives
trading. He is a frequent lecturer on legal and regulatory
issues relating to derivatives and has participated in several
joint CFTC/SEC public roundtables on Dodd-Frank Act-related
rulemaking.
Mr. Thum received his J.D. from the American University
Washington College of Law and his B.A. from Bucknell. He is
admitted to the bar in both New York and Pennsylvania, and I am
very pleased that Mr. Thum could be with us today. I welcome
his testimony, and I thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator. Let me introduce our
other panelists.
Stephen Merkel is executive vice president, general
counsel, and secretary of BGC Partners, positions he has held
since the formation of BGC's predecessor eSpeed in 1999. He is
the current chairman and a founding board member of the
Wholesale Market Brokers' Association, Americas, the
independent industry body representing the largest interdealer
brokers operating in North America wholesale markets across a
broad range of financial products. He serves as a member of the
supervisory board of ELX Futures, L.P., a fully regulated
electronic U.S. futures exchange. He is currently also
executive managing director, general counsel, and secretary of
Cantor Fitzgerald, L.P., which he joined in 1993. Thank you,
Mr. Merkel, for joining us.
Christopher Bury is a managing director at Jefferies &
Company in the fixed income's New York office and cohead of
rates trading and sales. Under Mr. Bury's leadership, Jefferies
has expanded its global rates trading and sales capabilities,
including attaining primary dealer status with the Federal
Reserve Bank of New York as well as the equivalent dealer
recognition in multiple European countries. Prior to joining
Jefferies in January 2009, Mr. Bury spent more than 13 years in
fixed income trading at Merrill Lynch, where he most recently
headed Merrill Lynch Government Securities, Inc., and was
trading manager of the USD agency desk. Prior to trading agency
debt, Mr. Bury traded USD interest rate swaps and options for
Merrill Lynch.
Gentlemen, your testimony will be made part of the record.
Please use your 5 minutes to make any comments that you would
like. Mr. Thum, please.
STATEMENT OF WILLIAM THUM, PRINCIPAL AND SENIOR DERIVATIVES
COUNSEL, THE VANGUARD GROUP, INC.
Mr. Thum. Chairman Reed, Ranking Member Crapo, and Members
of the Subcommittee, thank you for having me here today. My
name is William Thum, and I am a principal and senior
derivatives counsel at Vanguard.
Headquartered in Valley Forge, Pennsylvania, Vanguard is
one of the world's largest mutual fund firms. We offer more
than 170 U.S. mutual funds with combined assets of
approximately $1.7 trillion. We serve nearly 10 million
shareholders including American retirees, workers, families,
and businesses whose objectives include saving for retirement,
for children's education, or for a downpayment on a house or a
car.
Vanguard's mutual funds are subject to a comprehensive
regulatory regime and are regulated under four Federal
securities laws. As a part of the prudent management of our
mutual funds, we enter into swaps to achieve a number of
benefits for our shareholders including hedging portfolio risk,
lowering transaction costs, and achieving more favorable
execution compared to traditional investments.
Vanguard has been supportive of the Dodd-Frank Act's
mandate to bring regulation to the derivatives markets to
identify and mitigate potential sources of systemic risk.
Vanguard supports a phased implementation schedule over an
18- to 24-month period following rule finalization based on the
following objectives:
Number one, prioritizing risk reduction over changes to
trading practices and market transparency; Prioritizing data
reporting to inform future rulemaking related to trading
practices and market transparency to minimize a negative impact
on liquidity; Harmonizing overlapping U.S. and global
regulatory efforts; and Allowing immediate voluntary access for
all party types to the new platforms with mandated compliance
to apply initially to swap dealers and to major swap
participants.
In view of the time needed to digest the final rules and to
develop industry infrastructure; to implement complex
operational connections required for reporting, clearing, and
exchange trading; to educate clients on the changes and to
obtain their consent to trade in the new paradigm; and to
negotiate new trading agreements across all trading
relationships, Vanguard supports the following implementation
schedule:
Six months from final rules, the swap data repositories,
derivatives clearing organizations, SEFs, and middleware
providers must complete the build-out of their respective
infrastructures.
Six to 12 months from final rules, all participants should
voluntarily engage in reporting, clearing, and trading
platforms.
Twelve months from the final rules, all participants should
be mandated to report all swaps involving all parties. Dealers
and major swap participants should be mandated to clear the
first list of standardized swaps.
Eighteen months from the final rules, all participants
should be mandated to clear the first list of standardized
swaps. SEFs and commissions can analyze SDR swap data for
liquidity across trade types to make informed SEF trading
mandates, block trade size, and reporting delays. Dealers and
major swap participants should be mandated to trade the first
list of standardized swaps made available for trading on SEFs.
And 2 years from the final rules, all participants should
be mandated to trade the first list of standardized swaps made
available for trading on SEFs with delayed public reporting of
block trades based on historical relative liquidity.
The need for a phased implementation schedule is supported
by studies which have identified significant differences in
liquidity between the swaps and futures markets. While futures
trading is characterized by high volumes of a limited range of
trade types of small sizes and limited duration, the swaps
market has an almost unlimited range of trade types of much
larger sizes with a much longer duration. Swaps liquidity
varies dramatically with high liquidity for 2-year U.S. dollar
interest rate swaps and much smaller liquidity in credit
default swaps on emerging market corporate entities.
The potential negative consequences to liquidity are best
demonstrated by the impact of the premature public reporting of
large-sized block trades. When quoting a price for a block
trade, dealers typically charge a slight premium to the then
current market price for a similar trade of a more liquid size.
Once the trade is executed, the dealer executes one or more
liquid-sized mirror trades at current market prices to lay off
its position and to flatten the market exposure.
The premature public dissemination of block trades will
provide the market with advance knowledge of the dealer's
imminent trading and is, therefore, likely to move the market
against the dealer. Fund investors will ultimately bear the
increased price of relevant trades or the increased costs of
establishing positions using multiple trades of liquid sizes.
The CFTC's proposed test for block trade size and the CFTC
and SEC's proposed time delay for the public dissemination of
block trade data are too conservative and are likely to have a
serious negative impact on liquidity. Particularly as such
proposals address market transparency and not market risk, the
more prudent approach would be to make informed decisions based
on a thorough analysis of market data with larger block trade
sizes and more prompt public reporting for the most liquid
products and lower sizes and delayed reporting for less liquid
products.
There are a number of other significant issues related to
SEF trading mandates proposed by each of the CFTC and SEC which
I am happy to discuss. Such issues include the CFTC's proposed
requirement for Requests for Quotes to be distributed to a
minimum of five dealers, the CFTC's and SEC's mandate for
participants to take into account or to interact with other
resting bids and offers, the CFTC's requirement for there to be
a 15-second delay involving crossing trades, and the need for
harmonization across the CFTC and SEC rulemaking to avoid
unnecessary complexities.
Thank you for the opportunity to share our views with the
Subcommittee, and we will be pleased to serve as a resource for
the Members with respect to the swaps rulemaking exercise.
Chairman Reed. Thank you very much.
Mr. Merkel, please.
STATEMENT OF STEPHEN MERKEL, EXECUTIVE VICE PRESIDENT AND
GENERAL COUNSEL, BGC PARTNERS, INC.
Mr. Merkel. Thank you, Chairman Reed and Ranking Member
Crapo, for providing this opportunity to participate in today's
hearing.
My name is Stephen Merkel, and in addition to my role at
BGC Partners, I am the chairman of the Wholesale Markets
Brokers' Association, Americas, an independent industry body
whose membership includes the largest North American
interdealer brokers. I am here today representing the members
of the WMBA.
The WMBA recently filed a comment letter to the SEC and
CFTC summarizing the positions we have taken on several of
their proposals over the last year. I would ask permission to
submit this letter for the record.
Chairman Reed. Without objection.
Mr. Merkel. Thank you.
Wholesale brokers are today's marketplaces in the global
swaps market and, as such, can be a prototype for prospective
independent and competitive swap execution facilities, or SEFs.
As we sit here today, interdealer brokers are facilitating the
execution of hundreds of thousands of over-the-counter trades
corresponding to an average of $5 trillion in notional size
across a wide range of asset classes. Although the Dodd-Frank
Act created the term ``SEF,'' the concept of counterparties to
a trade utilizing an intermediary to execute transactions has
been around for a very long time.
At the core of Title VII is a competitive marketplace. The
Dodd-Frank Act specifically did not dictate that all mandatory
trades go through monopolistic exchanges and instead permits
these trades to be executed across an array of over-the-counter
competitive SEFs. SEFs do not operate as siloed, monopolistic
exchanges. Instead, we operate as competing execution venues
where BGC and its competitors aggressively vie with each other
to win their customers' business through better price,
provision of superior market information and analysis, deeper
liquidity and better service. It is vital to ensure that SEFs
are brought under the new regulatory regime in such a way that
fosters the competitive nature of OTC markets and continues to
provide a deep source of liquidity for market participants.
WMBA member firms are currently fully functional, having
the capacity to electronically capture and transmit trade
information with respect to transactions executed on our
trading platforms as well as the ability to execute or trade
swaps by accepting bids and offers made by multiple
participants through any means of interstate commerce,
including use of electronic and voice trading platforms.
I would suggest that there are four critical elements
regulator need to get right.
First, SEFs must not be restricted from deploying the many
varied trade execution methods successfully used today.
Second, regulators need to carefully structure a public
trade reporting system that takes into account the unique
challenges of swaps trading. If the rules do not properly
define the size of block trades, information, and time delays,
it will sure cause a negative impact on liquidity, disturbing
end users' ability to hedge commercial risk and to plan for the
future.
Third, the goal of pretrade transparency must be realized
through means that are already developed by wholesale brokers
to garner and disseminate pricing information, and not by
artificial mechanisms that may restrict market liquidity for
end users and traders.
Finally, regulations should support the formation of a
common regulatory organization for SEFs to implement and
facilitate compliance with the new regulatory regime to prevent
a ``race to the bottom'' for rule compliance and enforcement
programs. As it relates to modes of execution, Dodd-Frank Act
expressly permits swaps to be executed by SEFs using any means
of interstate commerce. The WMBA believes the SEC's
interpretation of the SEF definition is consistent with the
statute as it allows trade execution through any means of
interstate commerce including requests for quotes systems,
order books, auction platforms, or voice brokerage trading.
WMBA believes that this approach should be applied
consistently to all trading systems or platforms and will
encourage the growth of a competitive marketplace for trade
execution facilities. By contrast, the CFTC's pending rule is
much more restrictive than Dodd-Frank's express language and
prescribes specific modes of execution for different types of
trades.
In fact, the CFTC's proposed rule would severely limit the
ability of SEFs to communicate with their customers
telephonically in the course of a transaction. Such a
limitation of voice communications is completely inconsistent
with the statute.
I thank you for your time and look forward to answering any
questions that you may have.
Chairman Reed. Thank you very much.
Mr. Bury, please.
STATEMENT OF CHRIS BURY, COHEAD OF RATES SALES AND TRADING,
JEFFERIES & COMPANY, INC.
Mr. Bury. Good morning. My name is Chris Bury and I am the
Cohead of Rates Sales and Trading for Jefferies and Company.
Chairman Reed and Ranking Member Crapo, thank you for inviting
me to testify this morning regarding the emergence of swap
execution facilities, or as they have come to be known, SEFs.
Jefferies is a full-service global securities and
investment banking firm that, for almost 50 years, has been
serving issuers and investors. We provide investment banking
and research, sales, and trading services and products to a
diverse range of corporate clients, Government entities,
institutional investors, and high net worth individuals. Over
the last 5 years, our firm's annual revenue, equity market
capitalization, and global head count have increased
significantly, with now almost $3 billion in annualized net
revenue, over $4 billion in equity market value, and soon to be
3,600 employees.
It bears noting that during the same period, that is,
during the financial crisis, at no time did Jefferies seek or
receive taxpayer assistance. As a publicly traded company on
the New York Stock Exchange, our capital comes solely from the
markets, and Jefferies' ability to persevere and emerge from
the financial crisis positioned for growth and diversification
can best be attributed to the firm's focus on a strong capital
position, ample liquidity, and sound risk management.
There are a few key points that Jefferies would like to
convey to the Subcommittee. First, we are ready to go. From our
perspective, the architecture, infrastructure, and technology
necessary to bring the over-the-counter derivatives markets
into an era of transparency, disperse counterparty risk, and
open access are in place. Just as we are a leading provider of
liquidity and execution in stocks and bonds, we believe we can
become a leading provider to buyers and sellers of derivatives.
The market awaits the adoption of final rules. It is a fallacy
to suggest that rules should be delayed to allow more time for
this market structure to develop.
Second, we believe that those sections of Title VII of
Dodd-Frank pertaining to SEF trading of derivatives are
necessary to remedy the artificial barriers to entry in the OTC
derivatives market.
Third, implementation time lines should be the top priority
at this juncture. The proposed rules are generally clear and
understandable. The market needs the certainty of when the
rules will become applicable far more than it needs any more
suggestions about how bilateral agreements offer an alternative
to central clearing.
Fourth, it is vitally important to guard against the
development of market structures that enable opaque, bilateral
contract relationships to continue to exist. Current
standardized execution agreement proposals for centrally
cleared swaps do nothing but preserve the closed and
anticompetitive elements of these markets as they existed prior
to the financial crisis.
Fifth, the adoption of the rules and a clear time line for
implementation for Title VII will bring to the markets the same
clear benefits gained from similar developments in equities and
futures markets: Increased access, expanded competition,
improved price transparency, and decentralized risk. For years,
firms such as Jefferies were effectively locked out of being a
dealer in the OTC market by virtue of a series of artificial
barriers and requirements that perpetuated a closed system. The
weaknesses and lack of true competition of that closed system
exacerbated the credit crisis of 2008 to the great expense of
our economy.
We support the implementation of SEF trading as quickly and
responsibly as possible. We believe that these provisions will
increase transparency, reduce systemic risk, increase
competition, and broaden access to centralized clearing within
the derivatives marketplace, all of which will benefit the
American taxpayer.
Our industry is approaching full readiness for standardized
OTC derivatives contracts to begin trading on SEFs. If the
proposed rules are implemented by the end of 2011, Jefferies
would anticipate that trading volumes will begin increasing by
the fourth quarter of this year, and then increase
significantly into 2012 as we approach final implementation of
mandatory SEF trading of standardized derivatives. A firm time
for mandatory SEF trading on the most standardized swaps will
be instrumental for the market to achieve its full potential.
In conclusion, Jefferies believes that implementation of
Title VII reforms will unless full market forces held in check
by entrenched business models and we are ready and eager to
compete in the derivatives marketplace.
Thank you for inviting me to testify today and I look
forward to any questions the Subcommittee may have.
Chairman Reed. Well, thank you, gentlemen, for your
excellent testimony.
Senator Toomey and I await momentarily a vote. We have a
few minutes to get over there, but I think the best way to
proceed would be to allow me to ask a general question to the
panel and then recognize Senator Toomey for a question, and
then be prepared for an avalanche of written questions because
we, unfortunately, will not be able to explore in as much
detail at this moment as we wanted to.
But just picking up on something Mr. Bury said about these
model contracts that are being developed that you suggest might
be literally a choke point for access to the SEFs and the
different trading platforms, can you comment further on that in
terms of your experience or what you see, and then I will just
ask Mr. Merkel and Mr. Thum to comment, too, about this,
because I believe some of the major associations are beginning
to develop these types of contracts as an alternative to wider
use of the SEFs. I think it is an important question. Mr. Bury,
please.
Mr. Bury. OK. One example currently that is taking place in
the marketplace is an execution agreement on cleared swaps.
There has to be some market framework and work flow by which
people can start to transact in the cleared environment. So
there is currently an industry documentation effort that is
underway where people can identify their counterparties and
their clearing members for cleared derivatives.
Unfortunately, at this point, we feel that it is overly
complex and contains too many complicated built-in credit
checking limits that, at the end of the day, somewhat limit
people's ability and potential to transact on other venues or
engage other counterparties. It is overly complex, and I think
if the market shifts and market participants combined with
regulators overseeing the effort and helping the process along
focus on, I guess, the mandated clearing and acceptance,
immediate acceptance of clearing of transactions, then you will
not have to rely on a byzantine or complicated documentation
framework.
Chairman Reed. Thank you.
Mr. Merkel, then Mr. Thum, and thank you.
Mr. Merkel. I would agree that there are real pressures and
forces that work against breaking the status quo and opening up
areas for competition, whether it is in clearing, whether it is
in execution, whether it is in modes of execution, and I think
that those, in many cases, those barriers to changing the
status quo are subtle and difficult to discern. I do think
there is an issue that I do not think the agencies are as
focused on as they might be, and I think that is a considerable
problem. There are some protections in Dodd-Frank with respect
to this issue, with respect to impartial access, with respect
to nondiscriminatory clearing. I have not seen in the
regulations that have come out much sensitivity to getting into
that in detail.
I have seen in the regulations, to the contrary, there are
almost no references to them other than parroting what is in
the statute, and what regulations we are seeing that come out
in detail are not even part of Dodd-Frank. So I think the
regulators are focusing very much on recreating marketplaces or
reengineering marketplaces without regard to the effects on
liquidity, but spending almost no time looking at trying to
foster a competitive landscape.
Chairman Reed. Mr. Thum, please.
Mr. Thum. Before you can have mandated SEF trading, you
have to have mandated clearing. Before you can have mandated
clearing, you have to have the documentation in place. Indeed,
ISDA and the FIA are developing standard addendums to overlay
over existing futures agreements which the market has in place.
Unfortunately, there is no standard futures agreement in the
market. Every dealer has its own unique futures agreement.
Those futures agreements are developed for futures. They are
not developed for swaps.
There are business issues related to the trading of swaps,
even clearing swaps, that are unique to swaps that are
different from futures that will have to be addressed. There is
an overlay that ISDA and the FIA have developed to supplement
the existing futures agreement to allow central clearing.
Unfortunately, those have to be negotiated bilaterally between
every client and every clearinghouse and the existing futures
agreement may have to be upgraded, as well. This is an enormous
effort.
Certainly, Vanguard is engaged in this at present, but the
pipeline is limited in terms of the dealer's ability to digest
renegotiating all of their existing futures agreements and have
the addendum put in place. This will be a big problem in terms
of having a very condensed implementation schedule, which is
one of the reasons why I have laid out the sequence of having,
first, reporting to informed decision making on block trade
size and delays, then have clearing layered in, first through
swap dealers and major swap participants, then have clearing
laid in for the rest of the market, allowing 18 months to get
these documents signed up, and then, finally, SEF trading after
that.
Chairman Reed. Thank you very much.
Senator Toomey.
Senator Toomey. Thank you, Mr. Chairman.
Mr. Thum, I would like to follow up with you on this. First
of all, I would like to commend you. I think this is a very
sensible and very thoughtful proposal that lays out a phased
implementation that makes a lot of sense and, frankly, is very
helpful. My sense is that there is increasing consensus that
there needs to be a phased implementation, but it is not yet
clear to me that there is a complete consensus on what the
sequence will be, nor necessarily on the overall timing.
So you have touched on several reasons why this is
important, the comments you just made about the necessity of
getting the documentation in order. As I understand it, your
testimony suggests that there could be a negative impact on
liquidity if some of the rules, reporting rules, for instance,
are not informed by the market data. Could you elaborate a
little bit and maybe touch on other aspects, negative aspects
that you are concerned about in the marketplace if there is not
sufficient time for this implementation to occur?
Mr. Thum. Sure, and I think that is an excellent question.
I think that the problem is that, particularly as mandates are
layered in place, you could have a situation where those that
cross the finish line at an appropriate time consistent with
the mandate are allowed to continue to trade swaps, clear and
trade swaps, and those that do not get past the finish line,
either because their business is not large enough to allow them
through the pipeline at the dealer to get the documentation
signed up, to have their infrastructure developed, to have all
the operational connectivity in place, they will be effectively
locked out of the market because of an arbitrary time line that
does not take into consideration all the things that need to be
done.
In recent CFTC and SEC roundtables, a focus has been on
SDRs and gathering information. Once the final rules are in
place, the SDRs think it will be three to 6 months before they
are ready to be collecting the data and then have the data to
allow the commissions and the SEFs to make decisions on block
trade size and delays.
So there is a whole sequence of getting the data, having
the SDRs set up, getting the data in the door, allowing time
for the documentation to get clearing in place, and then once
you have the data, analyze the data, assess liquidity, set
appropriate block trade sizes and delays so that you can
effectively allow for SEF trading. But all these things have to
happen and they have to happen in sequence and they have to
happen once the rules are finalized.
Senator Toomey. And I gather the bottom line is your
concern is if it happens on too compressed a schedule, then
there are significant participants that could be actually just
frozen out of the activity until they are able to get up to
compliance, and I suppose, also, the danger of inappropriate
rules because they would not be informed by sufficient history.
Mr. Thum. Exactly, and the largest players, some of which
were mentioned today in the earlier panel, will probably get to
the finish line very quickly.
Senator Toomey. Right.
Mr. Thum. But the rest of the market may be left behind.
And, of course, the problem--the impacts on liquidity that have
been talked about in the various panels will be significant.
Senator Toomey. Thank you. Thank you, Mr. Chairman.
Chairman Reed. Thank you very much, Senator Toomey.
Gentlemen, thank you for your excellent testimony. We have
a vote that is underway, but again, we will, I am sure, be
responding, not just Senator Toomey and I, but others with
questions for you.
I want to thank all the witnesses for testifying today. We
appreciate both the time and effort you made to join us this
morning, your excellent testimony. It has been thoughtful. It
is also of great assistance to us, and I hope it is of great
assistance to the agencies, the SEC and the CFTC, because one
of the messages that has been consistent is coordination and
accommodation and synchronization of their efforts to regulate
the market.
I would also like to submit, without objection, for the
record a written statement from the Investment Company
Institute, ICI.
If Members of the Committee have their own written
statements or additional questions for the witnesses, please
submit them no later than close of business next Wednesday. The
witnesses' complete written testimony will become part of the
hearing record and we are happy to include supporting
documentation for the record. We ask that the witnesses respond
to any questions within 2 weeks, and note that the record will
close after 6 weeks in order for the hearing print to be
prepared.
Without further business, I will call the adjournment of
the hearing. Thank you.
[Whereupon, at 11:16 a.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF SENATOR MIKE CRAPO
Thank you, Mr. Chairman for holding this hearing on the development
of Swap Execution Facilities (SEFs).
There are a number of different electronic trading models that
could potentially be used for derivatives trading depending upon final
rules by the SEC, CFTC, and international regulators.
While Title VII of the Dodd-Frank Act states that the SEC and CFTC
shall consult and coordinate to the extent possible for the purposes of
assuring regulatory consistency and comparability, the lawyers for the
two agencies have not been able to agree what these terms means.
We should not then be surprised when the two agencies propose
inconsistent approaches to the same rule sets. For the Swap Execution
Facility rules, the SEC approach is more principles-based and is in
general far less prescriptive than that of the CFTC.
While the Dodd-Frank Act missed a great opportunity to merge the
SEC and CFTC and stop the bifurcation of the futures and securities
markets we should continue to push for more coordination and consistent
rules.
Swap Execution Facilities are likely going to dually register with
the two agencies and it makes a lot of sense for the two regimes to be
consistent.
While I applaud the SEC for taking a more flexible approach
relative to CFTC, both agencies need to make their rules more
accommodative of the different types of SEFs to provide maximum choice
in trade execution to market participants.
Under the CFTC SEF version, the proposed rule requires swap users
to request prices from no fewer than five dealers at a time.
This is generating a lot of controversy from the end user community
which argues it may ultimately serve to unnecessarily disadvantage end
users by limiting their ability to choose the appropriate number of
counterparties and mode of execution in the way they deem most
efficient and effective to hedge their commercial risk.
Since the Dodd-Frank Act stipulates that transactions required to
be cleared must also be executed on a SEF or designated contract market
there is significant interplay between the clearing, trading, and the
definition of block trades.
According to the end users, this could create a problem for some
less liquid trades that could be suitable for clearing, but not for
trade execution.
I have also been advised that the SEC's SEF approach is more
consistent with what the Europeans are looking at but have not acted
upon.
If we want to find a common international framework in order to
avoid regulatory arbitrage and avoid competitive disadvantages we need
to provide greater coordination and harmonization to get the rules
right rather than rushing them through.
______
PREPARED STATEMENT OF KEVIN McPARTLAND
Director of Fixed Income Research, TABB Group
June 29, 2011
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, thank you for inviting me today to discuss progress and
concerns surrounding the creation of swap execution facilities.
I'm Kevin McPartland, a Principal and the Director of Fixed Income
Research at TABB Group. TABB Group is a strategic research and advisory
firm focused exclusively on the institutional capital markets. Our
clients span the entire investment landscape including investment
banks, pension plans, mutual funds, hedge funds, high frequency
traders, FCMs, exchanges, and clearinghouses. We also operate
TabbFORUM.com, a peer-to-peer community site where top level industry
executives share thought leadership on important issues affecting the
global capital markets.
In order for this new market structure to be successful, swap
execution facilities must be given broad latitude in defining and
implementing their business models--this includes, but is not limited
to, the mechanisms used for trading and the risk profiles of their
members. This will promote the innovation and competition that has made
the U.S. capital markets the envy of the world.
It is also critical that the mechanisms to move trades quickly and
easily from execution to clearing are well defined. If market
participants worry that the trade they have just executed on a SEF
might later in the day be canceled due to a clearinghouse rejection,
confidence in the entire market model will erode quickly, and severely
limiting the transparency and systemic risk reduction Dodd-Frank was
intended to improve.
New Market Structure
Despite these open concerns, industry sentiment toward the creation
of swap execution facilities has turned positive. Based on a TABB Group
poll published in April 2011, of more than 140 market participants, 87
percent believe the creation of swap execution facilities will
ultimately be good for the swaps market. Of course, everyone defines
``good'' differently--good for liquidity, for transparency, for
profits. Regardless, this demonstrates how the market's view that
nearly every business model can--and most will--be adapted to work
under the proposed SEF rules.
That being said, no solution will satisfy all market participants--
nor should it. Regulators should not try to appease everyone in the
market but instead focus their efforts on creating a set of rules that
work.
To finalize the new swaps-market rules, regulators can either
attempt to fit these products into old structures (such as a futures
structure), or develop new mechanisms to manage these products. TABB
Group believes regulators should look toward the new rather than wrap a
new product in an old package. To that end, we are all presented with
the rare opportunity to build up this market from scratch in such a way
that it will function effectively for farmers who need to hedge crop
prices and global financial institutions working to keep the world's
economy flowing.
The exchange model was created over 200 years ago long before
electronic trading and high-speed market data. Today we're creating a
new 21st-century market, but why would a paradigm from the 1800s make
sense as a starting point? With little legacy legislation, rules can be
written based on what we know now, not based on the structures
developed in 1934 via the Securities and Exchange Act.
Trading Style and Membership Requirements
In order to develop the most suitable market structure for swaps,
we must provide swap execution facilities with the freedom to utilize
trading styles and different business models, ensuring every market
participant has the most efficient access to liquidity possible.
Firstly, SEFs should not be driven to a particular trading model.
Despite the inclusion of the Request for Quote model in proposals from
the CFTC and SEC, regulators are keen to have swaps trade through an
order book with continuous two-sided quotes.
TABB Group research shows that order-book trading will emerge
naturally--81 percent believe we will have continuous order book
trading of vanilla interest rate swaps within 2 years of SEF rule
implementation. However, the existence of an electronic order book does
not guarantee liquidity nor that market participants will trade there.
For example, of the roughly 300,000 contracts available for trading
in the electronic U.S. equity options market, only 100 of those make up
about 70 percent of the volume. The rest are seen as so illiquid that
it is often easier to trade OTC with a broker rather than try and
execute that same contract on the screen. Furthermore, despite the
market's electronic nature, TABB Group research shows that in 2010 as
much as 97 percent of all options trading volume generated by asset
managers was done over the phone.
Second, we should encourage SEFs to set membership requirements to
encourage a variety of liquidity pools. The U.S. equity market presents
a good example. Thirteen registered exchanges and another 55
alternative execution venues exist to trade U.S. equities for a total
of sixty-eight. Why? Because different market participants trade in
different ways and have different needs. Some like to trade in large
size, some small; some are very concerned about price while others are
more concerned about getting a trade done quickly. Because of this, the
equity market responded with new venues to meet those needs.
Although the equities market is very retail focused and the swaps
market is purely institutional, a similar dynamic exists. The trading
style and needs of a mutual fund are very different from those of a
major dealer or a hedge fund. We therefore should encourage swap
execution facilities to develop business models that help all market
participants, and allow SEFs to compete with each other for whichever
client base they chose to serve. This means allowing SEFs to not only
define the method of trading, but requirements for entry.
For example, if you were willing to pay the membership fee, a
restaurant supply store would be willing to sell you food for your
family in the same bulk sizes they provide for restaurants. But since
most American families do not need to buy food in bulk, we choose
instead to shop at a local supermarket. The price per unit might be
higher, but it is a more suitable way to shop for a family of four.
Although the analogy might appear flippant, it explains why loosely
defined tiers must still exist for trading swaps.
In the current market, a smaller player cannot trade in the
interdealer market even if they had the capital and desire. In the new
market, as long as a trading firm meets the requirements set forth by
the SEF, they will be--and should be--allowed in to trade. The
important point to note is that setting membership requirements for
SEFs is not exclusionary, but instead intended to help market
participants trade in the most suitable environment possible.
Clearing
Open access to clearing will play a huge role in the success or
failure of all SEFs. It is central clearing, not the SEF construct
itself, that will allow easier access to trading and new market
participants to enter. But a clearinghouse providing only the ability
to accept SEF executed trades is not enough.
SEFs are intent on providing click-to-trade functionality, that
when you accept a price on the screen with a click of the mouse,
whether in an order book or via a request for quote, the trade is done.
However, a trade is not done until it is accepted for clearing--
something the SEFs have little if any control over. That raises the
question: can a SEF ensure a trade will be accepted for clearing before
it allows the trade to execute? And even if it can, is that its
responsibility?
Either way, clearing certainty is crucial to the success of SEFs.
If market participants worry that the trade they have just executed on
a SEF might later in the day be canceled due to a clearinghouse
rejection, confidence in the entire market model will erode quickly and
limit severely the transparency and systemic risk reduction Dodd-Frank
was intended to improve. It is critical that a mechanism be put in
place to formalize this process, ensuring the market can have full
faith in the trades they execute on a SEF.
Size of the Market and Open Issues
There has been considerable speculation as to the number of SEFs
that will exist. The wildest number I've heard is 100 which is simply
unrealistic. If the U.S. equities market has 68 venues and the U.S.
futures market has 3 main players, the swaps market will fall somewhere
in the middle.
Our research shows also that nearly 60 percent of market
participants believe the ideal number of SEFs per asset class is three
to four, resulting in 15 to 20 SEFs covering interest rates, credit,
FX, commodities, and equities. There will be many more than that to
start but not 100--our list at TABB Group shows as many as 40 firms
that plan to apply--but 87 percent of our study participants believe
that SEF consolidation will begin 2 years or less from the date of rule
implementation.
Timing
Rulewriting delays at the CFTC and SEC are unfortunate but
necessary. The financial services industry is ready to move ahead to
the next chapter, but it is more important that these rules are written
properly rather than in haste. Despite the fact that so much
uncertainty remains, the industry is moving ahead with preparations for
SEF trading, central clearing, trade reporting and the myriad of other
new requirements.
We are now in the pre-SEF era. Business models and technology are
being finalized, but most SEFs are ``registration-ready'' and trade
flow is beginning to pick up on the screen as most everyone has
accepted that these changes are inevitable. Tradeweb, a trading
platform set to register as a SEF, tells us their trading volume is up
47 percent from last year. We see this level of growth happening with
several of the existing platforms. Even if trading mandates don't take
effect until the fourth quarter of 2012--a timeframe that seems more
realistic--the change is so enormous for most swaps traders that
getting started now should present just enough time to make the switch.
Winners and losers, however, will not be chosen until after
regulatory mandates are in place. Too many market participants still
exist and see little economic incentive to shift, in addition to those
new market participants waiting in the wings. But even still, working
together, regulators and the industry have made significant progress
during the past year, clarifying the view of what the post- Dodd-Frank
world of swaps trading will look like.
As rules are finalized, it is critical that while putting in place
necessary oversight, new OTC derivatives rules encourage the innovation
and competition that have made the U.S. capital markets the most envied
in the world.
Thank you.
PREPARED STATEMENT OF NEAL B. BRADY
Chief Executive Officer, Eris Exchange, LLC
June 29, 2011
PREPARED STATEMENT OF BEN MACDONALD
Global Head of Fixed Income, Bloomberg, L.P.
June 29, 2011
My name is Ben Macdonald and I am the Global Head of Fixed Income
for Bloomberg L.P., a privately held independent limited partnership
headquartered in New York City. Bloomberg is not owned by any swap
market participants and does not itself engage in trading of swap
instruments on a proprietary basis. Our customer base for our
information and news services, market analytics and data services, and
for our platforms for electronic trading and processing of over-the-
counter (OTC) derivatives is evenly distributed among buy-side and
sell-side entities. We serve the entire spectrum of the financial
market and, being independent, we do not have a bias toward nor are we
beholden to any particular element of the market.
Bloomberg's core business is the delivery of analytics and data on
approximately 5 million financial instruments, as well as information
and news on almost every publicly traded company through the Bloomberg
Professional service. \1\ More than 300,000 professionals in the
business and financial community around the world are connected via
Bloomberg's proprietary network. Over 17,000 individuals trade on our
system across all fixed income product lines alone, with over 50,000
trading tickets a day coming over that network. Virtually all major
central banks and virtually all investment institutions, commercial
banks, Government agencies and money managers with a regional or global
presence are users of the Bloomberg Professional service, giving
Bloomberg extraordinary global reach to all relevant financial
institutions that might be involved in swap trading.
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\1\ Bloomberg employs over 12,900 employees around the world,
including more than 2,300 news and multimedia professionals at 146
bureaus in 72 countries, making up one of the world's largest news
organizations.
---------------------------------------------------------------------------
I lead Bloomberg's team of professionals dedicated to establishing
a registered Swaps Execution Facility (SEF) and Security-Based Swaps
Execution Facility (SB-SEF) under Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act of 2010. As the largest
independent player in the market in terms of electronic trading and
processing of OTC derivatives, Bloomberg has an extensive suite of
capabilities, experience, technical expertise, infrastructure,
connectivity, and community of customers that uniquely position our
fIrm to provide unbiased, independent intermediary SEF and SB-SEF
services to both the buy-side and the sell-side in the domestic and
international swaps market. All major swaps dealers utilize our
platform. Over 600 firms use Bloomberg's existing platform to trade
interest rate swaps and credit default swaps. We provide connectivity
for both the buy-side and the sell-side to multiple clearinghouses. We
facilitate exchange-traded as well as voice brokered swaps on our
system.
Bloomberg fully supports the creation of the regulated swaps
marketplace envisioned by Dodd-Frank. We believe that the Dodd-Frank
mandatory clearing and reporting requirements will significantly
mitigate systemic risk, promote standardization, and enhance
transparency. We enthusiastically anticipate being a robust and capable
competitor in the SEF and SB-SEF markets, and we believe our
participation as an independently owned firm will bring innovation,
reliability, efficiency, transparency, and reduction of systemic risk
to the markets.
Bloomberg's Existing Electronic Swaps Platforms: Experience and
Innovative Leadership
Our views on the subject of SEF \2\ regulation are significantly
informed by our long and successful experience derived from our
existing OTC swaps trading platforms. We believe that body of expertise
and experience provides Bloomberg the opportunity to engage the new
world of SEF registration and operation from a considerable position of
strength. Our current OTC derivatives trading platforms were built on
the idea of adding transparency to the market by creating electronic
functions that streamline trading in swaps and provide efficient,
competitive access to swaps pricing, all of which aligns very well with
the goals of Title VII of Dodd-Frank.
---------------------------------------------------------------------------
\2\ Our reference to ``SEFs'' in this testimony is intended to
include SB-SEFs as well unless otherwise indicated.
---------------------------------------------------------------------------
Bloomberg's current ``single-dealer'' and ``multidealer''
derivatives trading tools allow multiple participants to view and trade
swaps with multiple dealers. In Bloomberg's single-dealer page system,
enabled participants are readily able to view different dealer pages
(simultaneously if preferred) that display the price and volume at
which each dealer has indicated it will trade. After reviewing the
displayed prices a participant can then request to execute against a
single-dealer page's displayed price with the understanding that the
dealer can accept, counter, or reject execution. Multidealer pages
display a ``composite price'' reflecting the general market based on
participating dealers' respective price submissions. After reviewing
the displayed ``composite price'' a participant can request specific
prices from 3 dealers. The participant then has a limited time to
accept or reject a trade with any of the dealers. Under both models,
Bloomberg provides real-time trade reporting to warehouses, data
repositories, and clearing venues.
Bloomberg also has hosted various ``request for quote'' (RFQ)
systems for OTC derivatives for the past 5 years. These RFQ systems
allow entities seeking liquidity to secure bids and offers from
particular market participants they would like to engage in a
transaction. Our Bloomberg Bond Trader System, a competitive
multidealer RFQ platform for U.S. and foreign government securities,
has been active for more than 13 years. We are confident that these
very successful RFQ models provide directly relevant experience and are
the proper conceptual paradigm for establishing a SEF under Dodd-Frank.
In addition to operating a very robust RFQ system, we also operate
our ``AllQ'' system that shows market participants on one screen the
stack of liquidity reflected in the range of streaming bids and offers
from multiple dealers in the market. Users can perform their price
discovery, and then click and trade with their dealer of choice.
Both our RFQ and our AllQ systems empower properly enabled market
participants to hit on executable bids and offers, or engage in
electronic negotiation with counterparties on indicative bids. Our
experience and success with our RFQ and AllQ platforms provide us
confidence that we will be able to satisfy the operational requirements
established by Dodd-Frank for SEF registration. We intend to be
prepared to begin SEF operations on the implementation date of the
relevant SEF regulations issued by Commodity Futures Regulatory
Commission (CFTC) and the Securities Exchange Commission (SEC),
provided that the two regulators create synchronized rules governing
trading protocols, board composition and financial reporting.
Responses to the Committee's Specific Areas of Inquiry
Bloomberg most certainly supports Dodd-Frank's call for the
emergence of SEF-style trading, increased mandatory clearing and post-
trade transparency through reporting. In particular, Bloomberg is very
supportive of the Federal regulators providing clear and specific rules
for clearing, and post-trade transparency, which together serve as the
most significant tools for reducing systemic risk and attaining a
reformed, financially sound derivatives marketplace that benefits
market participants and the Nation as a whole. The systemic risk
threats that arose in 2008-2009 were associated with insufficient
clearing and post-trade transparency and were not the result of
execution failures. Indeed, market participants know very well what
they want and need regarding fair and efficient execution on electronic
platforms. Sophisticated market participants do not really need or want
Federal regulators micro-managing execution protocols; no one should
expect that market participants will necessarily want to trade the way
the Federal Government prefers that they trade. It is also not the
proper role of the Federal regulators to go to extravagant lengths to
define the most favorable terms of execution for trading by
sophisticated investors. Rather, while it is clearly a very important
function, what is incumbent on Federal regulators is only to insure
that the market is fair and competitive and that participants
themselves have enough information to assess whether they know that
they are getting a fair price.
The risk that Federal regulators run in micromanaging execution
protocols is that they will increase the direct cost of trading--with
no compensating benefit to customers--and impose significant
constraints and indirect costs that incentivize market participants to
revert to forms of trading that evade the excessive regulation and
those costs. It will not be difficult for market participants to find
wholly lawful ways to conduct their trading in non-SEF environments,
including taking their trading to foreign jurisdictions where the U.S.
rules do not apply.
Consequently, we do not believe that the same degree of regulation
warranted for clearing and post-trade reporting is desirable from a
public policy perspective with regard to trade execution protocols.
Rather, in providing rules on trading protocols, Federal regulators
should specifically avoid over-regulation and imposing ``one size fits
all'' mandates, but should instead use a principles-based approach
which encourages flexibility by SEFs that will maximize their
innovation, competition and responsiveness to the needs of the market.
Failure to invest SEFs with the ability to employ flexibility in their
trade execution protocols actually jeopardizes the realization of the
public policy objectives that Dodd-Frank seeks to attain.
In his letter of invitation to this hearing, Chairman Reed outlined
six specific areas of inquiry of interest to the Subcommittee. In
response, Bloomberg offers the following views:
Question 1: What is the status of industry readiness for trading on
SEFs? What in your view is the timeline for the movement of
substantial volumes of derivatives activity onto SEFs? What, if
any, documentation is necessary for market participants to
migrate their trading activity onto SEFs?
There are different degrees of readiness for trading on SEFs among
market participants and among products. Some market participants,
including banks, hedge funds, insurers, and other sophisticated
entities, are very eager and ready to begin trading on SEFs; other
market participants will require more time to prepare themselves for
SEF trading. The same is true with regard to the ``readiness'' of
different products for SEF trading. The volume and liquidity of what
are viewed as ``plain vanilla'' interest rate swaps, credit default and
currency swaps make them prime candidates for early movement to SEF
trading; but other products will take more time. The CFTC and SEC are
currently engaged in the process of determining how to properly phase
in participants and products as part of their effort to effectively
sequence the implementation of the range of Dodd-Frank regulations and
we believe the relative ``readiness'' of market participants and
products ought to play a significant role in that phasing/sequencing
determination.
It is also worth noting however that if ``readiness'' is viewed in
the context of capability to conduct the type of electronic trading
envisioned for SEFs, Bloomberg in specific and the financial industry
in general are very ready to commence SEF trading. The volume of
electronic trading over the past decade has been enormous and the
infrastructure to create the connectivity for SEF trading certainly
exists. We have witnessed ever increasing migration of trading to a
variety of electronic trading formats. Bloomberg itself has witnessed
an accelerated use of our electronic platforms since the passage of
Dodd-Frank a year ago. That said, SEF-style trading which entails
multilateral trading and direct routing to clearinghouses remains rare
since most current OTC swaps trading is bilateral and not submitted for
clearing.
We further note that if ``readiness'' is viewed from the
perspective of the state of the legal framework for the clearing and
increased transparency imposed by Dodd-Frank for SEF trading, there is
considerable work still ahead for the industry. Clearing and
transparency are certainly priority objectives of Dodd-Frank's SEF
regime as means to mitigate systemic risk, but those rules have not yet
been articulated in final form by the CFTC and SEC. We expect those
rules, once promulgated in final form, will be novel in many ways and
costly, and it will take time for market participants to do all the
things necessary to accommodate those rules in terms of legal
documentation, installation of technology, and other critical
responses. With regard to documentation alone, there is a significant
number of necessary items that will require time for negotiation
between interested parties and for careful drafting by lawyers. \3\
Ultimately, how much swaps trading moves to SEF platforms will be
influenced by the complexity of the agencies' final rules and the cost
of those rules for clearing, documentation, reporting and the like that
must be borne by SEFs and their customers. The objective of those rules
should be to minimize their cost and complexity in order to incentivize
optimal movement of swaps trading to properly regulated SEF platforms
and to minimize avoidance of those newly regulated SEF platforms.
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\3\ While not an exhaustive list, the large and complex range of
documents that need to be negotiated and drafted include: derivative
clearing organization agreements, swaps data repository agreements and
protocols, platform participant agreements and end user agreements,
independent service vendor agreements, and information sharing
agreements with corresponding SEFs and Designated Contract Markets
trading swaps to effectuate compliance relating to position limits and
manipulation issues. In addition, SEFs will have to draft participant
rulebooks, compliance manuals, connectivity agreements, antimoney
laundering documentation, and numerous other vital documents.
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Question 2: How do you expect the open access requirements for
clearinghouses to impact the development of SEFs? Are there any
obstacles to clearinghouses meeting this open and
nondiscriminatory access requirement?
Bloomberg has been successful in securing access to various
clearinghouses for its existing OTC trading platforms. While mandatory
swaps clearing as envisioned by Dodd-Frank is not completely worked out
in all regards, we are cautiously optimistic that in a reasonable time
we will have no significant problems with clearing for trades on our
registered SEF platforms. We believe that our connectivity to a range
of clearinghouses will provide end users a desirable choice in where to
clear their swaps, which effectuates one of the objectives of Dodd-
Frank which was to empower end users in that regard. It should be
emphasized however that the cost and uncertainty of the rules on
clearing swaps under the Dodd-Frank regime could be impediments to the
proliferation of SEFs.
Question 3: What regulatory and market-based incentives can facilitate
the development and success of SEFs?
Bloomberg believes that the Federal regulatory agencies should
focus on creating well-articulated rules for clearing and post-trade
market transparency, and to the maximum extent possible allow SEFs
flexibility in fashioning their own trading protocols. In our judgment
the most important incentive that can facilitate the development and
success of SEFs is to give the SEFs significant latitude on the trading
protocols they use. Maximizing the flexibility for SEFs to devise and
implement their trading protocols will encourage innovation,
competition and market responsiveness. In contrast, prescribing trading
protocols by regulation will inhibit attainment of those public policy
objectives and decrease overall SEF participation and market liquidity.
It is noteworthy that the swaps market evolved to give swaps users
highly customizable products that allowed them to meet specific
investment objectives. Losing that tradition of flexibility to overly
constrictive trading requirements would be destructive to the goal of
encouraging a vibrant, competitive, and innovative SEF market.
Question 4: Do any barriers currently exist in the derivatives market
that would inhibit the entrance of additional SEFs into the
marketplace? Are there ways to mitigate those barriers, and how
would those changes impact the derivatives market?
Given the technology afforded by the Internet and connectivity,
technological barriers to entry are relatively low. However, we do
perceive several elements of the Dodd-Frank regime that could create
barriers to entry in terms of increased risk and cost for entities
considering registering as SEFs.
Micromanagement and Overregulation of Trading Protocols
Central clearing ensures that there is sufficient capacity for the
market to absorb losses within its own structure and trade reporting
promotes price transparency which ensures price fairness. Both of these
elements of Dodd Frank are beneficial to the market and ultimately to
the individual investor and taxpayer. But trying to regulate with
specificity the trading protocols may discourage the use of SEFs, and
undermine the benefits that Dodd-Frank was designed to deliver through
SEFs by reintroducing risk and removing liquidity. For example,
mandating the use of a central limit order book would encourage the
style of algorithmic and speculative trading that were at the center of
the equities flash crash in 2010. Such an event would not be possible
with today's fixed income trading structure.
Similarly, mandating the number of dealers that can participate in
an RFQ may actually create liquidity risk because investors will only
be able to trade if there are the mandated minimum number of market
participants available. The proposed minimum requirement of having 5
respondent dealers for a SEF's RFQ platform reduces the end user's
ability to achieve best execution because they will be forced to
advertise their activities to a broader set of market participants than
they may want. This problem is particularly acute with regard to block
trades. The same can be said of imposing mandatory protocols that would
require a block trade to interact with any resting interests on a SEF.
Liquidity providers responding to a block trade RFQ need to factor
in the size of the trade when quoting a price. Imposing a trading
protocol that could materially alter the size of a block trade would
inject uncertainty for the liquidity provider responding to an RFQ.
Rather, liquidity providers should be given the option of interacting
with resting bids (i.e., standing bids posted on platforms without
reference to any particular RFQ) if it is consistent with their trading
strategy and best execution, and SEFs should be allowed to offer that
flexibility to the market. \4\ Similarly, liquidity seekers tend to
vary their strategies as to the number of liquidity providers they
include in an RFQ. Their strategies typically depend on the particular
instrument (and its relative liquidity), the direction (long or short),
and the size of the transaction they are seeking to execute. Liquidity
seekers should have the flexibility in any given transaction to
identify the optimal number of liquidity providers from which to seek
bids.
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\4\ So too, forcing a minimum number of dealers into the RFQ
process will likely increase cost with no compensating offset or
benefit. We observe that the SEC's proposed SBSEF rules do not mandate
transmission of an RFQ to a minimum or maximum number of liquidity
providers.
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Nor should SEFs be limited to one model or methodology in
disseminating composite indicative quotes to the market. Developing a
meaningful composite is a complex process involving intricate
proprietary algorithms and each SEF has a compelling reason to develop
a composite indicative quote that represents the most accurate
reflection of the markets that meets participant needs and expectations
for accuracy. A SEF that offers a composite that is consistently
``away'' from the actual market will quickly be disciplined and
marginalized by participants' disuse of that SEF.
There are other examples of the wisdom and value of allowing SEFs
flexibility at the trading protocol level but the above illustrations
convey the point that overly prescriptive mandates in this area are
both unnecessary to the desirable functioning of SEFs and will
effectively create barriers to SEFs coming into the market.
Cost of Compliance
The greatest current cost of compliance lies in the different rules
promulgated by the CFTC and SEC. While Dodd-Frank requires these two
agencies to coordinate their approach, it remains to be seen whether
they will sufficiently do so in their respective final regulations. If
they fail to do so, the result will be that to operate as both a SEF
and a SB-SEF an entity will be compelled to create two separate
companies to trade what in essence are the same type instruments. This
not only affects each potential SEF and SBSEF but also their clients,
many of whom use the same individual traders to trade both instruments
types. The effective doubling of costs due to the inability of the two
regulatory bodies to sufficiently coordinate their rules would not only
be regrettable but creates a barrier to entry for the independent firms
wishing to become SEFs and SBSEFs. It is fair to ask whether that may
only auger concentration in the SEF space and a ``too-big-to-fail''
situation for the remaining SEF's in the marketplace, which is exactly
the opposite of what Congress intended when they included the idea of
SEFs in Dodd-Frank.
The creation of a complex set of overly detailed rules to manage
trading protocols within the SEF market will generate significant
regulatory compliance costs for SEFs which will have to be borne
ultimately by the end users of the SEF platforms. Such costs can be
mitigated by allowing the SEFs maximum flexibility to create their own
trading protocols.
Costs can further be reduced by providing a robust opportunity for
SEFs to contract with third party service providers for such things as
market surveillance, trade practice surveillance, real-time market
monitoring, investigations of possible rule violations and disciplinary
actions. In contracting for such services--while maintaining Dodd-
Frank's requirement that SEFs retain full, ultimate responsibility for
decision making involving those functions--SEFs can avoid the capital
and operational costs of creating the infrastructure of those functions
for themselves internally and thereby reduce both the cost of entry
into the SEF market and the cost of ongoing SEF operations.
Beyond being allowed to use the expertise of third party service
providers, SEFs also should be permitted to rely on the regulation and
oversight of market participants and swap products by swaps
clearinghouses rather than have to replicate essentially the same
activity at the SEF level. For example, if a clearinghouse accepts a
market participant for clearing purposes or accepts a swap for
clearing, the SEF should be permitted to rely on that assessment for
Core Principle compliance purposes regarding its obligation to
establish that the market participant is an eligible swap participant
or that the swap is not susceptible of manipulation under the SEF
regulatory regime.
Governance Constrictions
Dodd-Frank requires the agencies to minimize opportunity for
conflicts of interest in the governance of SEFs which would allow
anticompetitive behavior injurious to other market participants. Both
the CFTC and SEC have proposed regimes for mitigating conflicts of
interests through ownership limitations and structural governance
requirements. These rules were written to address risks arising from a
situation where a SEF would be owned and controlled by other market
participants who would be tempted to set SEF policy to advance their
own interests and to the detriment of other market participants and the
market in general.
Requiring all SEFs to meet these ownership and governance
constrictions is a serious and unnecessary barrier to entry in the case
of SEFs whose ownership structure does not present the risks that Dodd-
Frank's conflict of interest provisions were intended to prevent. \5\
Bloomberg is an independently owned entity, meaning that other market
participants do not have an ownership interest in the company. We are
not beholden to either buy side or sell side interests. There is no
public policy purpose in requiring Bloomberg or any other an
independently owned firm to jump through unnecessary hoops and contort
its governance to prescribed forms designed to prevent conflicts of
interest risks that demonstrably do not exist due to their independent
ownership structure and business model. We believe that where a SEF is
not owned by its customer-members or other market participants and
where the SEF can demonstrate a sufficient mitigation of legitimate
potential conflicts of interests the agencies should permit that SEF an
exemption from the governance restrictions which were designed to
redress conflicts arising from cases where market participants own and
control the SEF. Such an exemption would mitigate prospects that the
governance rules would serve as an unproductive barrier to entry for
independently owned SEFs who can bring to the market the competition
that Dodd-Frank sought to generate in swaps trading.
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\5\ While SEC has suggested they may require universal compliance
with these conflict/governance rules even for independent entities,
that view is not required by Dodd-Frank, nor is that interpretation a
requirement written into the CFTC's proposed rules. Beside being
irrational because independent entities do not present the governance
conflict risks the rules were designed to address, applying those rules
would add unnecessary cost to independent entities operations without
any countervailing public policy benefit.
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Extraterritoriality and International Harmonization
The swaps marketplace is a global business. A large percentage of
transactions on Bloomberg's swap platforms involve non-U.S. banks and
other foreign institutions. An entity seeking to register as a SEF
desires to have consistent standards applicable to both SEFs and market
participants across different jurisdictions. Without such coordination
a SEF may be put in the untenable position of enforcing rules against
certain participants that are inconsistent, or worse, conflicting with
foreign rules. Moreover, without harmonized and consistent standards a
SEF could be required to have one set of rules for U.S. participants
and another set of rules for non-U.S. participants, with a further set
of transaction-level rules based on the counterparties or underlying
instruments. The resulting legal uncertainty associated with an uneven
playing field and regulatory arbitrage can be a significant
disincentive to becoming a SEF, to maximizing a SEF's availability to
market participants, or to the scope of the products offered for
trading on the SEF.
Question 5: How do you expect the SEF marketplace to develop over time?
How many SEFs would you imagine operating in the United States
and around the world 5, 10, and 20 years after full
implementation of the derivatives title?
The existence of multiple SEFs will at least initially be a
function of asset classes (credit, interest rates, currencies,
commodities, equities) and market function (liquidity seekers versus
liquidity providers). Initially, one can fairly assume that there may
well be a larger number of SEFs in each asset class and market
function, which over time may yield to consolidation based on the
gravitation of the pool of liquidity to certain SEFs based on their
superior performance and their more favorable system functionality.
Having said that, predicting the number of SEFs globally is
complicated by the fact that outside the U.S. there are no specific
regimes to regulate swaps as SEFs are envisioned by Dodd-Frank. It can
be said that in terms of U.S.-registered SEFs, the number of SEFs will
be inversely proportional to the number and strength of barriers to
entry. In this regard, the problem we foresee with unnecessary and
unwise limitations on the flexibility of SEFs to determine their own
trading protocols will be paramount. To the extent that SEFs are
homogenous, required to fit a specific ``one size fits all'' regime on
trading protocols, they will increasingly resemble cookie cutter
utilities, providing less innovation and responsiveness to market
participants' evolving needs for those SEFs in the market and less
incentive for new SEFs to enter the market to compete with incumbent
SEFs. But the more flexible SEFs can be with their trading protocols
the more incentive there will be for all SEFs to distinguish themselves
with innovation, vigorous competition and increasingly more cost
effective functionality for the market--all of which enhances the
incentive for SEFs to come into the market in greater numbers.
Question 6: What policy considerations, if any, should Congress or the
regulators consider in order to better support the successful
development of SEFs?
The key public policy element we would suggest to Congress and the
Federal regulators to better support successful development of SEFs
relates to flexibility of trading protocols. There is little
disagreement that clearing and transparency are good for the market and
will reduce systemic risk created by large concentrations of derivative
positions. However, overly prescriptive methods of execution threaten
market liquidity and create risks of unintended adverse consequences
such as incentivizing trading that avoids SEFs (dark pools) and flight
to less regulated foreign markets. Enabling SEFs to rely on aspects of
the DCO compliance regime that would otherwise replicate compliance
obligations imposed on SEFs would reduce SEF costs and incentivize SEFs
to focus productively on their trading protocols which will maximize
innovation, competition and market responsiveness.
Conclusion
SEFs represent a very valuable opportunity to achieve the reduction
of systemic risk and transparency objectives of Dodd-Frank. Overly
constrictive swaps trading rules will seriously diminish the
contribution that SEFs can make to achieving those laudable public
policy objectives. It is imperative, especially at the outset of the
Dodd-Frank regime, that the regulations pertaining to SEFs do not
mitigate the promise SEFs represent to achieve those legislative
objectives which will keep the U.S. markets at the vanguard of
international finance. In our view, this means the Federal regulators
should not approach regulation of trade execution protocols from the
same conceptual perspective as may be required for clearing and post-
trade transparency. SEFs need operational flexibility at the trade
execution level and without it one should not expect a robust emergence
of SEFs or the ongoing innovation, competition and customer
responsiveness they can bring to the market.
On behalf of Bloomberg, I want to extend my appreciation for having
this opportunity to appear before the Subcommittee to express our
views. We are happy to be of further assistance to you as you continue
your deliberations on these extremely important issues.
______
PREPARED STATEMENT OF JAMES CAWLEY
Chief Executive Officer, Javelin Capital Markets
June 29, 2011
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, my name is James Cawley. I am Chief Executive Officer of
Javelin Capital Markets, an electronic execution venue of OTC
derivatives that will register as a SEF (or ``Swaps Execution
Facility'') under the Dodd Frank Act.
I am also here to represent the interests of the Swaps &
Derivatives Market Association or ``SDMA,'' which is comprised of
several independent derivatives dealers and clearing brokers, some of
whom are the largest in the world.
Thank you for inviting me to testify today.
Without a doubt, it is mission critical that central clearing,
increased transparency, and broader liquidity is properly achieved
under the Dodd-Frank Act for the OTC derivative markets. Toward that
goal, it is important that SEFs be allowed to properly function and
compete with each other whereby Congress and the Regulators ensure that
such organizations and their various execution models be neither
discriminated against, nor be penalized by trade workflow or
documentation efforts that show preference for one SEF over another.
Only by access to a fair, level, and open playing field, will SEFs
be properly able to play their part in the lessening of systemic risk,
to which the derivative marketplace contributed during the global
financial crisis of 2008.
Product Eligibility and Open Access
With regard to product eligibility to clearing, clearinghouses
should recognize that the fair majority of interest rate and credit
derivative products do qualify for clearing.
Regulators should be mindful to ensure that clearinghouses do not
favor acceptance of certain products that have built in trade
restrictions that impede open access or customer choice.
While intellectual property rights may protect innovation in the
short term, with regard to certain swap products or indices, they may
restrict trade and liquidity in the long term. Market participants
should be allowed to trade such products to meet their investor or
hedging objectives. Intellectual property rights for such products
should adapt with the post Dodd-Frank market place where anonymous and
transparent markets flourish.
Regulators should work with these IP holders to both ensure that
their rights are properly protected, and the prudential need of the
broader market is also protected.
Open Access to Clearinghouses
With regard to SEF access to clearinghouses, clearinghouses and
their constituent clearing members should do as the act requires--
accept trades on an ``execution blind'' basis. DCOs should not
discriminate against trades simply because they or they shareholders
dislike the method in which such trades occur.
Clearinghouses should refrain from using their SEF sign-up
documentation as a vehicle to restrict trade. As a precondition to
access, clearinghouses should not require that SEFs sign ``noncompete''
clauses, such that a clearinghouse's other businesses--be it execution
based or not--are inappropriately protected from outside competition.
Likewise clearing firms should not require that SEF's contract with
them to restrict the rights or privileges of end users, as a
precondition to SEF-clearinghouse connectivity. Such requirements serve
no prudential role with regard to risk mitigation and run contrary to
the open access provisions of the Dodd-Frank Act.
Real Time Trade Acceptance
Clearinghouses should not require that a SEF purposefully engage in
a trade workflow that adds latency or creates unnecessary steps in the
settlement process.
Instead, clearinghouses and their constituent clearing firms should
draw from their own proven and well tested experience in listed
derivatives. They should accept trades symmetrically and in ``real
time.''
Immediate acceptance of swaps trades into clearing is critical to
accomplishing the goals of the Dodd-Frank Act to reduce systemic risk,
increase trade integrity, and promote market stability.
Settlement uncertainty, caused by time delays between the point of
trade execution and the point of trade acceptance into clearing, can
destroy investor confidence in the cleared OTC derivatives markets.
As the CFTC has correctly asserted such a time delay or ``trade
latency,'' (which in the bilateral swaps markets can be as long as a
week) directly constrains liquidity, financial certainty, and increases
risk. \1\
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\1\ P. 13101. (Federal Register, Volume 76, No. 47, 3/10/11).
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Clearinghouses and their clearing members should do as the
regulators have required, accept trades into clearing immediately upon
execution on a SEF.
Execution Documentation Efforts
Regulators should be wary of certain incumbent efforts that claim
to bring execution certainty through documentation. Such documentation
sets in place workflow that clearly favors RFQ (Request for Quote)
execution models over exchange like central limit order books.
Such documentation denies the customer the right to trade
anonymously with multiple counterparties, because under such a
workflow, the dealer counterparty requires the identity of the customer
be known before a trade occurs.
This is not the case with documentation and workflow requirements
in the cleared derivatives markets of futures and options. In those
markets, buyers and sellers trade in multiple trade venues where trade
integrity, counterparty anonymity and optimal liquidity is assured
through access to multiple counterparties.
Such restrictive workflow and documentation should be seen for what
it is--nothing more than a transparent attempt to limit customer
choice, restrict trade, and drain liquidity.
Conclusion
In conclusion, the role of the Swap Execution Facility with regard
to lessening systemic risk should not be understated.
To fulfill the SEF's role in fostering greater liquidity and
transparency, Congress and the regulators should continue to be
proactive and protect the market against Dodd-Frank implementation
``chokepoints.'' They should continue to ensure that all SEFs have fair
and open access to clearing and the marketplace.
______
PREPARED STATEMENT OF WILLIAM THUM
Principal and Senior Derivatives Counsel, The Vanguard Group, Inc.
June 29, 2011
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, thank you for having me here today. My name is William
Thum and I am a Principal and Senior Derivatives Counsel at Vanguard.
Headquartered in Valley Forge, Pennsylvania, Vanguard is one of the
world's largest mutual fund firms. We offer more than 170 U.S. mutual
funds with combined assets of approximately $1.7 trillion. We serve
nearly 10 million shareholders including American retirees, workers,
families, and businesses whose objectives include saving for
retirement, for children's education, or for a downpayment on a house
or a car.
Vanguard's mutual funds are subject to a comprehensive regulatory
regime and are regulated under four Federal securities laws. As a part
of the prudent management of our mutual funds, we enter into swaps to
achieve a number of benefits for our shareholders including hedging
portfolio risk, lowering transaction costs, and achieving more
favorable execution compared to traditional investments.
Vanguard has been supportive of the Dodd-Frank Act's mandate to
bring regulation to the derivatives markets to identify and mitigate
potential sources of systemic risk.
Vanguard supports a phased implementation schedule over an 18- to
24-month period following rule finalization based on the following
objectives:
prioritizing risk reduction over changes to trading
practices and market transparency;
prioritizing data reporting to inform future rulemaking
related to trading practices and market transparency (to
minimize a negative impact on liquidity);
harmonizing overlapping U.S. and global regulatory efforts;
and
allowing immediate voluntary access for all party types to
the new platforms with mandated compliance to apply initially
to swap dealers and major swap participants.
In view of the time needed to digest the final rules and develop
industry infrastructure; to implement complex operational connections
required for reporting, clearing, and exchange trading; to educate
clients on the changes and obtain their consent to trade in the new
paradigm; and to negotiate new trading agreements across all trading
relationships, Vanguard supports the following implementation schedule:
6 months from final rules: Swap Data Repositories,
Derivatives Clearing Organizations, SEFs, and middleware
providers must complete the build-out of their respective
infrastructures.
6 to 12 months from final rules: All participants should
voluntarily engage in reporting, clearing, and trading
platforms.
12 months from final rules: All participants should be
mandated to report all swaps involving all parties. Dealers and
major swap participants should be mandated to clear the first
list of ``standardized swaps.''
18 months from final rules: All participants should be
mandated to clear the first list of ``standardized swaps.''
SEFs and Commissions can analyze SDR swap data for liquidity
across trade types to make informed SEF trading mandates, block
trade size and reporting delays. Dealers and major swap
participants should be mandated to trade the first list of
``standardized swaps'' ``made available for trading'' on SEFs.
2 years from final rules: All participants should be
mandated to trade the first list of ``standardized swaps''
``made available for trading'' on SEFs with delayed public
reporting of block trades based on historical relative
liquidity.
The need for a phased implementation schedule is supported by
recent studies which have identified significant differences in
liquidity between the swaps and futures markets. While futures trading
is characterized by high volumes of a limited range of trade types of
small sizes and limited duration, the swaps market has an almost
unlimited range of trade types of much larger sizes with a much longer
duration. Swaps liquidity varies dramatically with high liquidity for
2-year U.S. dollar interest rate swaps, and much smaller liquidity in
credit default swaps on emerging market corporate entities.
The potential negative consequences related to liquidity are best
demonstrated by the impact of the premature public reporting of large-
sized block trades. When quoting a price for a block trade, dealers
typically charge a slight premium to the then current market price for
a similar trade of a more liquid size. Once the block trade is
executed, the Swap Dealer executes one or more liquid-sized mirror
trades at current market prices to lay-off its position and to flatten
its market exposure.
The premature public dissemination of block trade details will
provide the market with advance knowledge of the dealer's imminent
trading and is therefore likely to move the market against the dealer.
Fund investors will ultimately have to bear either the increased price
of relevant trades, or the increased costs of establishing positions
using multiple trades of liquid sizes.
The CFTC's proposed test for block trade size, and the CFTC and
SEC's proposed time delay for the public dissemination of block trade
data are too conservative and are likely to have a serious negative
impact on liquidity. Particularly as such proposals address market
transparency and not market risk, the more prudent approach would be to
make informed decisions based on a thorough analysis of market data
with larger block trade sizes and more prompt public reporting for the
most liquid products and smaller sizes and delayed reporting for less
liquid products.
In addition to the need for SDRs, DCOs, and SEFs to establish fully
functional platforms, the central clearing of derivatives will require
the negotiation (and possibly renegotiation) of all existing master
trading agreements to establish the required clearing relationships for
swaps. While ISDA and the Futures Industry Association are working on a
standard form of addendum for cleared swaps to add to parties' futures
agreements, as there is no market standard form of futures agreement,
and existing futures agreements may not address a number of key
business issues related to the clearing of swaps, the futures agreement
itself is likely to require significant renegotiation.
Even if the larger market participants can promptly work through
the process with dealers, many smaller participants could effectively
be cut out of the swaps market altogether if the documentation process
is not completed ahead of the clearing deadline.
There are a number of other significant issues related to the SEF
trading mandates proposed by each of the CFTC and SEC which I am happy
to discuss in the question and answer period. Such issues include the
CFTC's proposed requirement for ``Requests for Quotes'' to be
distributed to a minimum of 5 dealers, the CFTC's and SEC's mandate for
participants to ``take into account'' or to ``interact with'' other
resting bids and offers (including indicative bids and offers), the
CFTC's requirement for there to be a ``15 second delay'' involving
crossing trades, and the need for harmonization across the CFTC and SEC
rulemaking to avoid unnecessary complexities.
Thank you for this opportunity to share our views with the
Subcommittee and we will be pleased to serve as a resource for the
Members with respect to the swaps rulemaking exercise.
______
PREPARED STATEMENT OF STEPHEN MERKEL
Executive Vice President and General Counsel, BGC Partners, Inc.
June 29, 2011
Chairman Reed, Ranking Member Corker, and Members of the
Subcommittee, thank you for providing this opportunity to participate
in today's hearing.
My name is Stephen Merkel. I am the Executive Vice President,
General Counsel, and Secretary for BGC Partners, a leading global
interdealer broker of over the counter financial products. \1\ BGC
Partners was created in August 2004, when Cantor Fitzgerald separated
its interdealer brokerage business to create BGC Partners. We are a
leading global intermediary to the wholesale financial markets,
specializing in the brokering of a broad range of financial products
including fixed income, rates, foreign exchange, equities, equity
derivatives, credit derivatives, futures, and structured product
markets.
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\1\ BGC Partners, Inc. (NASDAQ: BGCP) (www.bgcpartners.com) is a
leading global intermediary to the wholesale financial markets,
specializing in the brokering of a broad range of financial products
including fixed income, rates, foreign exchange, equities, equity
derivatives, credit derivatives, futures, and structured product
markets. BGC offers a full range of brokerage services including price
discovery, trade execution, straight through processing and clearing,
settlement and access to electronic trading services through its
eSpeed, BGC Trader and BGC Pro brands. On April 1, 2008, BGC merged
with eSpeed to form a world-class provider of voice and electronic
brokerage services in the global marketplace. The combined company is
BGC Partners, Inc. Since its separation from Cantor Fitzgerald in 2004,
BGC has expanded to 24 offices worldwide with over 1,700 brokers and
approximately 2,700 employees. In 2005, BGC merged with Maxcor
Financial Group, integrating two leading brokerage firms. This was
followed by the acquisitions of ETC Pollak and Aurel in Paris.
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I am testifying today in my capacity as the Chairman of the
Wholesale Markets Brokers' Association, Americas (the ``WMBAA''), an
independent industry body whose membership includes the largest North
American interdealer brokers: my firm, BGC Partners, as well as GFI
Group, ICAP, Tradition and Tullett-Prebon. \2\
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\2\ The WMBAA is an independent industry body representing the
largest interdealer brokers operating in the North American wholesale
markets across a broad range of financial products. The WMBAA and its
member firms have developed a set of Principles for Enhancing the
Safety and Soundness of the Wholesale, Over-The-Counter Markets. Using
these Principles as a guide, the WMBAA seeks to work with Congress,
regulators, and key public policy makers on future regulation and
oversight of institutional markets and their participants. By working
with regulators to make wholesale markets more efficient, robust, and
transparent, the WMBAA sees a major opportunity to assist in the
monitoring and consequent reduction of systemic risk in the country's
capital markets. The five founding members of the WMBAA are BGC
Partners; GFI Group; ICAP; Tradition, and Tullett-Prebon. More about
the WMBAA can be found at: www.WMBAA.org.
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I welcome this opportunity to discuss with you the emergence of
swap execution facilities (SEFs) under the Dodd-Frank Wall Street
Reform and Consumer Protection Act (``Dodd-Frank'' or ``DFA''). I hope
to share the perspective of the primary intermediaries of over-the-
counter (OTC) swaps operating today, both here in the United States and
across the globe.
In my written testimony, I plan to cover the following points:
Readiness. In terms of readiness, BGC and its fellow WMBAA
member firms are currently fully functional as market
intermediaries in the OTC derivatives markets and will be ready
to initiate SEF operations on day one. Wholesale brokers are
today's central marketplaces in the global swaps markets and,
as such, can serve as a prototype for prospective independent
and competitive SEFs.
Voice and electronic modes of trade execution. Wholesale
brokers are experts in fostering liquidity and transparency in
global swaps markets by utilizing trade execution methodologies
that feature a hybrid blend of knowledgeable and qualified
brokers, as well as sophisticated electronic technology. The
CFTC's proposed rules are inconsistent with the statute in the
way that they limit how trades are executed, most particularly
in how they limit trades that occur utilizing voice or
telephonic communication. Such a limitation is inconsistent
with the statute's clear language that ensures that SEFs can
utilize ``any means of interstate commerce.'' The SEC's
proposed rule is much more flexible and consistent with the
statute.
Block trade size and preserving liquidity and anonymity in
the market. Liquidity in today's swaps markets is fundamentally
different than liquidity in futures and equities markets, and
the unique characteristics of this liquidity are what naturally
determine the optimal mode of market transparency and trade
execution. The CFTC's proposal could jeopardize liquidity in
the markets by relying on inappropriate factors to determine a
block trade. This would harm the ability of investors to manage
large positions, impact the ability of counterparties to engage
in anonymous price discovery and, ultimately, increase the cost
of risk management to end users. The definition of block trade
must be based on hard market data to minimize unintended
negative consequences.
Competition. It is vital that the rules be consistent with
the clear and unambiguous provisions in the statute ensuring
that clearinghouses provide SEFs ``nondiscriminatory access''
to clearing. To be consistent with the statute this must
include direct and indirect actions that not only inhibit
access to clearing, but also actions that would bundle the
services of a clearinghouse that operates an execution facility
(exchange or SEF), thereby providing favorable treatment to
their own affiliates over their independent competitors.
Another form of discrimination includes treating differently
SEF traded contracts and those traded on exchanges in
liquidation. The CFTC's proposed rule needs to be changed to
ensure that in liquidation there is identical treatment of the
cleared contract regardless of the venue it traded.
Essential Elements That Regulators Need To Get Right Under Title VII
The final regulations enacted by the Commodity Futures
Trading Commission (``CFTC'' or ``Commission'') and Securities
and Exchange Commission (``SEC'' or ``Commission'' and,
together with the CFTC, the ``Commissions'') must be consistent
with the plain language of Dodd-Frank and allow for multimodes
of execution as Congress intended. SEFs must not be restricted
from deploying the many varied and beneficial trade execution
methodologies and technologies successfully used today to
execute swaps transactions.
There must be harmonization between the CFTC and SEC, as
well as consistency in international regulation.
New regulations must be phased-in appropriately to prevent
unnecessary disruption to the markets.
Regulators must use a flexible approach to SEF
registration, permitted modes of trade execution and impartial
access. Regulations should support the formation of a common
regulatory organization (CRO) for SEFs to implement and
facilitate compliance with the Commissions' rules. The CRO
would ensure that a single, consistent standard is applied
across multiple SEFs and prevent a ``race to the bottom'' for
rule compliance and enforcement programs.
Background on Wholesale Brokers
In terms of actual operations, WMBAA members provide a marketplace
for a relatively small number of sophisticated institutional buyers and
sellers of OTC financial products where their trading needs can be
matched with other sophisticated counterparties having reciprocal
interests in a transparent, yet anonymous, environment. To persons
unfamiliar with our business, I often describe interdealer brokers as a
virtual trading floor where large financial institutions buy and sell
financial products that are not suited to, and therefore rarely traded
on, an exchange.
As we sit here today, interdealer brokers are facilitating the
execution of hundreds of thousands of OTC trades corresponding to an
average of $5 trillion in notional size across the range of foreign
exchange, interest rate, U.S. Treasury, credit, equity, and commodity
asset classes in both cash and derivative instruments. WMBAA member
firms account for over 90 percent of intermediated swaps transactions
taking place around the world today.
Wholesale brokers provide highly specialized trade execution
services, combining teams of traditional ``voice'' brokers with
sophisticated electronic trading and matching systems. As in virtually
every sector of the financial services industry in existence over the
past 50 years, wholesale brokers and their dealer clients began
connecting with their customers by telephone. As technologies advanced
and markets grew larger, more efficient, more diverse and global, these
systems have advanced to meet the changing needs of the market. Today,
we refer to this integration of voice brokers with electronic brokerage
systems as ``hybrid brokerage.'' Wholesale brokers, while providing
liquidity for markets and creating an open and transparent environment
for trade execution for their market participants, do not operate as
single silo and monopolistic ``exchanges.'' Instead, we operate as
competing execution venues, where wholesale brokers vie with each other
to win their customers' business through better price, provision of
superior market information and analysis, deeper liquidity and better
service. Our customers include large national and money center banks
and investment banks, major industrial firms, integrated energy and
major oil companies and utilities.
Increasingly, the efficiencies of the market have inevitably led to
a demand for better trading technology. To that end, we develop and
deploy sophisticated trade execution and support technology that is
tailored to the unique qualities of each specific market. For example,
BGC's customers in certain of our more complex, less commoditized
markets may choose among utilizing our electronic brokerage platforms
to trade a range of fixed income derivatives, interest rate
derivatives, foreign exchange options, repurchase agreements and energy
derivatives entirely on screen. Alternatively, they can execute the
same transaction through instant messaging devices or over the
telephone with qualified BGC brokers supported by sophisticated
electronic technology. It is important to note that the migration of
certain products to electronic execution was not, and has never been,
because of a regulatory or legal mandate but simply part of the natural
evolution and development of greater market efficiencies in particular
markets. Conversely, the persistence of customer preference for trade
execution through telephonic communications for certain products,
despite the apparent efficiencies associated with electronic trading in
other similar products in the same markets, reflects those customers'
preference for the unique advantages that ``voice'' brokers can provide
in liquidity formation with respect to less-liquid or more bespoke
products.
The critical point is that competition in the marketplace for
transaction services has led interdealer brokers to develop highly
sophisticated transaction services and technologies that are well
tailored to the unique trading characteristics of the broad range of
swaps and other financial instruments that trade in the OTC markets
today. Unlike futures exchanges, we enjoy no execution monopoly over
the products traded by our customers. Therefore, our success depends on
making each of our trading methods and systems right for each
particular market we serve. From decades of competing for the business
of the worlds' largest financial institutions, we can confirm that
there is no ``one size fits all'' method of executing swaps
transactions.
Dodd-Frank Impact on Swaps Market Structure: Clearing and Competing
Execution
Title VII of Dodd-Frank was an earnest and commendable effort by
Congress to reform certain aspects of the OTC swaps market. The DFA's
core provisions relating to clearing and trade execution are: (1)
replacing bilateral trading where feasible with central counterparty
clearing; and (2) requiring that cleared swaps transactions between
swaps dealers and major swaps participants be intermediated by
qualified and regulated trading facilities, including those operating
under the definition of ``swap execution facilities'' through which
``multiple participants have the ability to execute or trade swaps by
accepting bids and offers made by multiple participants in the facility
or system, through any means of interstate commerce . . . .'' \3\
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\3\ See, Commodity Exchange Act (CEA) Section 1a(50).
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These two operative provisions seek to limit the current market
structure where swaps and the underlying counterparty risk may be
traded directly between counterparties without the use of trading
intermediaries or clearing and to replace it for most transactions with
a market structure in which a central clearing facility acts as the
single counterparty to each market participant (i.e., buyer to each
seller and seller to each buyer) and where those cleared transactions
must be traded through SEFs and other intermediaries and not directly
between the counterparties.
In enacting these structural changes, DFA wisely rejected the
anticompetitive, single silo exchange model of the futures industry, in
which clearing and execution are intertwined, thereby giving the
exchange an effective execution monopoly over the products that it
clears. \4\ Rather, by requiring central clearing counterparties to
provide nondiscriminatory access to unaffiliated execution facilities,
DFA promotes a market structure in which competing SEFs and exchanges
will vigorously compete with each other to provide better services at a
lower cost in order to win the execution business of sophisticated
market participants. In this regard, DFA preserves the best competitive
element in the existing swaps landscape: competing wholesale brokers.
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\4\ As the Justice Department observed in a 2008 comment letter to
the Treasury Department, where a central counterparty clearing facility
is affiliated with an execution exchange (such as in the case of U.S.
futures), vertical integration has hindered competition in execution
platforms that would otherwise have been expected to: result in greater
innovation in exchange systems, lower trading fees, reduced ticket size
and tighter spreads, leading to increased trading volume and benefits
to investors. As noted by the Justice Department, ``the control
exercised by futures exchanges over clearing services . . . has made it
difficult for exchanges to enter and compete.'' In contrast to futures
exchanges, equity and options exchanges do not control open interest,
fungibility, or margin offsets in the clearing process. The absence of
vertical integration has facilitated head-to-head competition between
exchanges for equities and options, resulting in low execution fees,
narrow spreads, and high trading volume. See, Comments of the
Department of Justice before the Department of the Treasury Review of
the Regulatory Structure Associated With Financial Institutions,
January 31, 2008. Available at http://www.justice.gov/atr/public/
comments/229911.html.
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BGC and the WMBAA members heartily support Dodd-Frank's twin
requirements of clearing and intermediation. Their advocacy of swaps
intermediation is fundamental to their business success in fostering
liquidity, providing price transparency, developing and deploying
sophisticated trading technology tools and systems and operating
efficient marketplaces in global markets for swaps and other financial
products.
Critical Elements To Get Right
There are many things to get right under DFA. Given that DFA
requires all clearable trades to be transacted through an intermediary
(either an exchange or a SEF), it is essential that regulators get the
following aspects of this new regime right:
1. Permit multimodes of swap execution, consistent with
Congressional intent.
2. Ensure harmonization between agencies and foreign regulators.
3. Allow for the appropriate implementation of final rules.
4. Utilize a flexible approach to SEF registration, permitted modes
of trade execution, and impartial access.
5. Recognize the important role a common regulatory organization can
play in ensuring the integrity of the SEF industry.
1. Permitted Modes of Execution
As previously stated, DFA defines SEFs as utilizing ``any means of
interstate commerce'' to match swaps counterparties. This is an
appropriate allowance by Congress, as the optimal means of interaction
in particular swaps' markets varies across the swaps landscape.
Congress recognized that it was best left to the marketplace to
determine the best modes of execution for various swaps and, thereby,
foster technological innovation and development. Congress specifically
did not choose to impose a federally mandated ``one-size-fits-all''
transaction methodology on the regulated swaps market.
As the swaps market has developed, it has naturally taken on
different trading, liquidity and counterparty characteristics for its
many separate markets. For example, in more liquid swaps markets with
more institutional participants, such as certain U.S. Treasury, foreign
exchange and energy products, wholesale brokers operate fully
interactive electronic trading platforms, where counterparties can view
prices and act directly through a trading screen and also conduct a
range of pre- and post-trade activities like online price analysis and
trade confirmation. These electronic capabilities reduce the need for
actual voice-to-voice participant interaction for certain functions,
such as negotiation of specific terms, and allow human brokers to focus
on providing market intelligence and assistance in the execution
process. And yet, even with such technical capabilities, the blend of
electronic and voice assisted trading methods still varies for
different contracts within the same asset class.
In markets for less commoditized products where liquidity is not
continuous, BGC Partners and its competitors provide a range of
liquidity fostering methodologies and technologies. These include
hybrid modes of: (1) broker work-up methods of broadcasting completed
trades and attracting others to ``join the trade;'' and (2) auction
based methods, such as matching and fixing sessions. In other swaps
markets, brokers conduct operations that are similar to traditional
``open outcry'' trading pits where qualified brokers communicate bids
and offers to counterparties in real time through a combination of
electronic display screens and hundreds of installed, always-open phone
lines, as well as through other email and instant messaging
technologies. In every case, the technology and methodology used is
well calibrated to disseminate customer bids and offers to the widest
extent and foster the greatest degree of liquidity for the particular
market.
Permitted Use of Voice and Hybrid Trade Execution Platforms
The WMBAA feels strongly that the CFTC's proposed rules regarding
SEFs do not reflect the DFA's requirement that SEF transactions can be
executed ``through any means of interstate commerce.'' Specifically, in
restricting the use of voice-based systems for those clearable trades
that must be executed on a SEF, the CFTC has proposed a more
restrictive regime than the statute dictates. A rigid implementation of
the SEF framework will devastate existing voice and ``hybrid'' systems
that are currently relied upon for liquidity formation in global swaps
markets. ``Hybrid brokerage,'' which integrates voice with electronic
brokerage systems, should be clearly recognized as an acceptable mode
of trade execution for all clearable trades. The combination of
traditional ``voice'' brokers with sophisticated electronic trading and
matching systems is necessary to provide liquidity in markets for less
commoditized products where liquidity is not continuous. Failure to
unambiguously include such systems is not only inconsistent with Dodd-
Frank but will severely limit liquidity production for a wide array of
transactions. BGC and our fellow WMBAA members are concerned that such
a restrictive SEF regime will lead to market disruption and, worse,
liquidity constriction with adverse consequences for vital U.S. capital
markets.
The WMBAA strongly supports the SEC's interpretation of the SEF
definition as it applies to trade execution through any means of
interstate commerce, including request for quote systems, order books,
auction platforms or voice brokerage trading, because such an approach
is consistent with the letter and spirit of the Dodd-Frank Act and
ensures flexibility in the permitted modes of execution. The WMBAA
believes that this approach should be applied consistently to all
trading systems or platforms and will encourage the growth of a
competitive marketplace of trade execution facilities.
What determines which blend of hybrid brokerage is adopted by the
markets for any given swap product is largely the market liquidity
characteristic of that product, whether or not the instrument is
cleared. For example, a contract to trade Henry Hub Natural Gas
delivered in Summer 2017, though cleared, will generally be
insufficiently liquid to trade on a central limit order book. This is
true for many cleared products with delivery dates far in the future,
where market makers are unwilling to post executable bids and offers in
instruments that trade infrequently. In markets where price spreads are
wide or trading is infrequent, central limit order books are not
conducive to liquidity, but rather may be disruptive to it.
Critically, what determines which blend of hybrid brokerage is
adopted by the markets for any given swap product also has little to do
with whether the size of a transaction is sufficient or not to be
considered a block trade. Block trades concern the size of an order, as
opposed to the degree of market liquidity or presence of tight bid-
offer spreads. Depending on where block trade thresholds are set, block
trades can take place in all markets--from very illiquid markets to
highly liquid markets. Yet, central limit order book trade execution
generally only works well in markets with deep liquidity, and such
liquidity is not always available even within a usually liquid market.
For less liquid markets, even nonblock size trades depend on a range of
trading methodologies distinct from central limit order book or request
for quote systems. For these reasons, hybrid brokerage should be
clearly recognized as an acceptable mode of trade execution for all
swaps whether ``required'' or ``permitted.''
In addition, the regulatory framework for the swaps market must
take into consideration the significant differences between the trading
of futures on an existing exchange and the trading of swaps on SEF
platforms. While it may be appropriate, in certain instances, to look
to the futures model as instructive, overreliance on that model will
not achieve Congress' goal. Congress explicitly incorporated a SEF
alternative to the exchange-trading model, understanding that
competitive execution platforms provide a valuable market function.
Final rules governing SEFs should reflect Congressional intent and
promote the growth of existing competitive, vibrant markets without
impeding liquidity formation.
While certain requirements should be mandated during trade
execution (i.e., audit trail, trade processing, and reporting),
limitations on methodologies used in trade execution should be
considered carefully and weighed against potential implications on
liquidity formation. A rules regime that is overly prescriptive will
reduce the ability for SEFs to match buyers and sellers and restrict
trading liquidity, to the detriment of all market participants,
including end users.
2. Importance of Harmonization Between U.S. Agencies and Foreign
Regulators
While the substance of the proposed requirements for SEF
registration and core principles are extremely important, it is
equally, if not more, important that the final regulatory frameworks
are harmonized between the CFTC and SEC. A failure to achieve
harmonization will lead to regulatory arbitrage and unreasonably burden
market participants with redundant compliance requirements. As the
recent SEC CFTC joint proposed rule recognized, ``a Title VII
instrument in which the underlying reference of the instrument is a
``narrow-based security index'' is considered a security-based swap
subject to regulation by the SEC, whereas a Title VII instrument in
which the underlying reference of the instrument is a security index
that is not a narrow-based security index (i.e., the index is broad-
based), the instrument is considered a swap subject to regulation by
the CFTC.'' \5\
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\5\ Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping, 76 Fed. Reg. 29,818, 29, 845 (May 23, 2011).
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Any discrepancy in the Commissions' regulatory regimes will give
market participants incentive to leverage the slight distinctions
between these products to benefit from more lenient rules. Dodd-Frank's
framework was constructed to encourage the growth of a vibrant,
competitive marketplace of regulated SEFs. Final rules should be
crafted that encourage the transaction of OTC swaps on these trading
systems or platforms, as increased SEF trading will increase liquidity
and transparency for market participants and increase the speed and
accuracy of trade reporting to swap data repositories (SDRs). Certain
provisions relate to these points, such as the permitted methods of
trade execution, the scope of market entities granted impartial access
to SEFs, the formulation of block trade thresholds and compliance with
SEF core principles in a flexible manner that best recognizes the
unique characteristics of competitive OTC swaps markets.
Based upon the WMBAA's review of both the SEC and the CFTC's
proposed rules, the Commissions should consider the release of further
revised proposed rules incorporating comments received for additional
review and comment by market participants. This exercise would ensure
that the SEC and CFTC have the opportunity to review each of their
proposals and integrate appropriate provisions from the proposed rules
and comments in order to arrive at more comprehensive regulations.
Further, the CFTC and SEC are encouraged to work together to attempt to
harmonize their regulatory regimes to the greatest extent possible.
While some of the rules will differ as a result of the particular
products subject to each agency's jurisdiction, inconsistent rules will
make the implementation for SEFs overly burdensome, both in terms of
time and resources. As an example, the CFTC and the SEC should adopt
one common application form for the registration process. While
regulatory review of the application by the two agencies is
appropriate, reducing the regulatory burden on applicant SEFs to one
common form would allow for a smoother, timelier transition to the new
regulatory regime. Because the two proposed registration forms are
consistent in many respects, the differences between the two proposed
applications could be easily reconciled to increase regulatory
harmonization and increase efficiency.
Similarly, there needs to be a consistent approach with respect to
block trades. Not only should the threshold calculations be derived
from similar approaches, allowing for tailored thresholds that reflect
the trading characteristics of particular products, but the methods of
trade execution permitted by the Commissions should both be flexible
and within the framework of the SEF definition. U.S. regulations also
need to be in harmony with regulations of foreign jurisdictions to
avoid driving trading liquidity away from U.S. markets toward markets
offering greater flexibility in modes of trade execution. In
particular, European regulators have not formally proposed swap
execution rules with proscriptive limits on trade execution
methodology. We are not aware of any significant regulatory efforts in
Europe to mandate electronic execution of cleared swaps by
institutional market participants.
In a world of competing regulatory regimes, business naturally
flows to the marketplace that has the best regulations--not necessarily
the most lenient, but certainly the ones that have the optimal balance
of liquidity, execution flexibility and participant protections. U.S.
regulations need to be in harmony with regulations from foreign
jurisdictions to avoid driving trading liquidity away from U.S. markets
toward markets offering greater flexibility in modes of trade
execution.
3. Implementation of Final Rules
Compliance Timeline
The timeline for implementation of the final rules is as important
as, if not more important than, the substance of the regulations. We
recognize and support the fundamental changes to the regulation of the
OTC swaps markets resulting from the passage of the Dodd-Frank Act and
will commit the necessary resources to diligently meet the new
compliance obligations.
However, the CFTC and SEC must recognize that these changes are
significant and will result in considerable changes to the operations
and complex infrastructure of existing trading systems and platforms.
It is necessary that any compliance period or registration deadline
provides sufficient opportunity for existing trade execution systems or
platforms to modify and test systems, policies and procedures to ensure
that its operations are in compliance with final rules. It is very
difficult to determine the amount of time needed to ensure compliance
with the rules until the final requirements are made available.
However, providing market participants with an insufficient time frame
for compliance could harm the efficient functioning of the markets if
existing entities can no longer operate until they have built the
requisite platforms to comply with every measure in final rules.
Appropriate ``Phasing'' of Final Rules
Based upon the plain language of Dodd-Frank, the mandatory trade
execution requirement will become effective at the time that swaps are
deemed ``clearable'' by the appropriate Commission. Accepting the
premise that the mandatory trade execution requirement cannot be
enforced until there are identified ``clearable'' swaps and swaps are
``made available for trading,'' the Commissions need to ensure that a
functioning and competitive marketplace of registered SEFs exists at
the time the first trade is cleared and made available for trading. As
such, it is necessary that SEFs be registered with the CFTC or SEC, as
applicable, and available to execute transactions at the time that
trades begin to be cleared under the new laws. As stated previously,
the WMBAA estimates that its members currently account for over 90
percent of interdealer intermediated swaps transactions taking place
around the world today. If the SEF registration process is not
effectively finalized by the time various swaps are deemed clearable,
there could be serious disruptions in the U.S. swaps markets with
adverse consequences for broader financial markets.
Furthermore, requiring absolute compliance with final rules within
a short time frame is particularly troublesome for likely future SEFs,
as such a result may provide DCMs or national securities exchanges with
an unfair advantage in attracting trading volume due to their ability
to quickly meet the regulatory burdens. Congress distinguished between
exchanges and SEFs, intending for competitive trade execution to be
made available on both platforms. Congress also recognized the
importance of SEFs as distinct from exchanges, noting that a goal of
Dodd-Frank is to promote the trading of swaps on SEFs. The phasing in
of final rules for both exchanges and SEFs should be done concurrently
to ensure that this competitive landscape remains in place under the
new regulatory regime.
Not only will implementation of the final rules impact market
infrastructure, but the timing in which these rules are implemented
could significantly impact U.S. financial markets. As Commissioner Jill
Sommers recently remarked before the House Agriculture General Farm
Commodities and Risk Management Subcommittee, ``a material difference
in the timing of rule implementation is likely to occur, which may
shift business overseas as the cost of doing business in the U.S.
increases and create other opportunities for regulatory arbitrage.''
\6\ If the U.S. regulations are implemented before foreign regulators
have established their intended regulatory framework, it could put U.S.
markets at a significant disadvantage and might result in depleted
liquidity due to regulatory arbitrage opportunities.
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\6\ Statement of Jill E. Sommers before the Subcommittee on
General Farm Commodities and Risk Management, House Committee on
Agriculture, May 25, 2011, available at http://agriculture.house.gov/
pdf/hearings/Sommers110525.pdf.
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As the rulemaking process moves forward, we suggest the following
progression of rules be completed:
First, finalize product definitions. Providing the market
with certainty related to the scope of what constitutes a
``swap'' and ``security-based swap'' will allow market
participants to accurately gauge the impact of the other
proposed rules and provide constructive feedback on those
rules.
Second, implement final rules related to real-time
reporting for regulatory oversight purposes. The submission of
information to SDRs is an activity that takes place in many OTC
markets today and will not unduly burden those who must comply
with the requirement. Ensuring that the Commissions receive
current, accurate market data is a cost-effective method to
mitigate systemic risk in the short-term.
Next, establish block trade thresholds and finalize public
reporting rules. The information gathered by SDRs since the
implementation of the mandatory trade reporting requirement,
along with historical data made available by trade repositories
and trade execution facilities, can be used to determine the
appropriate threshold levels on a product-by-product basis. At
the same time, public reporting rules can be put into place,
including an appropriate time delay (that is consistent with
European and the other major global market rules) for block
trades.
After the reporting mechanics have been established, the
clearing mandate can be implemented. During this step, the
Commissions can determine what swaps are ``clearable'' and
subject to the clearing mandate, and clearinghouses can
register and begin to operate within the new framework.
Finally, once swaps are deemed clearable, the mandatory
trade execution requirement can be put into place for SEFs and
DCMs for those products made available for trading. All
clearable swaps will be made available for trading by SEFs, as
these trade execution platforms compete to create markets and
match counterparties. With the trade execution requirement's
implementation, it is imperative that rules for SEFs and DCMs
are effective at the same time, as implementing either entity's
rules prior to the other will result in an unfair advantage for
capturing market share of executable trades simply because they
could more quickly meet the regulatory burdens.
Taking adequate time to get the Title VII regulations right will
expedite the implementation of the worthy goals of Dodd-Frank: central
counterparty clearing and effective trade execution by regulated
intermediaries in order to provide end users with more competitive
pricing, increased transparency and deeper trading liquidity for their
risk management needs.
4. Flexible Approach to SEF Registration, Impartial Access, and Other
Areas of Concern
We support a flexible approach to evaluating applicant SEFs. As
noted above, Congress recognized and mandated by law trade execution
``through any means of interstate commerce,'' establishing a broad
framework that permits multiple modes of swap execution, so long as the
proposed mode of execution is capable of satisfying the statutory
requirements.
Moreover, any interpretation of the SEF definition must be broad,
and any trading system or platform that meets the statutory
requirements should be recognized and registered as a SEF. The new
regulatory framework should allow any SEF applicant that meets the
statutory requirements set forth in Dodd-Frank to be permitted to
operate under each Commission's rules in accordance with Dodd-Frank.
BGC and the WMBAA strongly support the SEC's interpretation of the
SEF definition as it applies to trade execution through any means of
interstate commerce, including request for quote systems, order books,
auction platforms or voice brokerage trading, because such an approach
is consistent with the letter and spirit of Dodd-Frank and ensures
flexibility in the permitted modes of execution. The WMBAA believes
that this approach should be applied consistently to all trading
systems or platforms and will encourage the growth of a competitive
marketplace of trade execution facilities.
Further, we are concerned with the CFTC's interpretation of the SEF
definition, as it limits the permitted modes of trade execution,
specifically restricting the use of voice-based systems to block
trades. The SEF definition and corresponding requirements in the CEA,
as amended by the Dodd-Frank Act, do not provide any grounds for this
approach and will severely impair other markets that rely on voice-
based systems (or hybrid systems, which contain a voice component) to
create liquidity.
Impartial Access to SEFs
The WMBAA is concerned that the CFTC's proposed mandate that SEFs
provide impartial access to independent software vendors (ISVs) is
beyond the legal authority in the CEA because it expands the impartial
access provision beyond ``market participants'' to whom access is
granted under the statute. Moreover, because SEFs are competitive
execution platforms, a requirement to provide impartial access to
market information to ISVs who lack the intent to enter into swaps on a
trading system or platform will reduce the ability for market
participants to benefit from the competitive landscape that provides
counterparties with the best possible pricing. Further, given the lack
of a definition of what constitutes an ISV and the significant
technological investments made by wholesale brokers to provide premiere
customer service, the ISV impartial access requirement leaves open the
possibility that SEFs could qualify as ISVs in order to seek access to
competitors' trading systems or platforms. This possibility would
defeat the existing structure of competitive sources of liquidity, to
the detriment of market participants, including commercial end users.
The WMBAA also believes the SEC should review its proposed
impartial access provisions to ensure that impartial access to the SEF
is different for competitor SEFs or national exchanges than for
registered security-based swap dealers, major security-based swap
participants, brokers or eligible contract participants. Congress
clearly intended for the trade execution landscape after the
implementation of Dodd-Frank to include multiple competing trade
execution venues, and ensuring that competitors cannot access a SEF's
trading system or platform furthers competition, to the benefit of the
market and all market participants.
Regulations Should Not Favor Execution on Particular Venues
The WMBAA believes that it is critically important that the
Commissions' regulations not favor trade execution on exchanges over
SEFs. An important part of the Dodd-Frank competitive landscape is that
derivatives clearing organizations (DCOs) accept trades from all
execution platforms and not advantage certain trading systems or
platforms over others.
WBMAA is concerned that certain proposed regulations will frustrate
the development of a truly competitive landscape. For instance, one of
the CFTC's proposed rules (proposed Regulation 39.13(g)(2)) would
require a DCO to use a five-business day liquidation horizon for
cleared swaps that are not executed on a designated contract market
(DCM), but would permit a DCO to use a one-business day liquidation
horizon for all other products that it clears, including swaps that are
executed on an affiliated DCM.
The WMBAA believes that this disparity is ill-founded. In the case
of two economically identical instruments--one executed on a SEF and
one executed on a DCM--the liquidation horizon for each should depend
upon liquidity characteristics such as average daily volume, standard
deviation of average daily volume and open interest. To require a
longer horizon simply because one of the two is traded on a SEF rather
than on a DCM is harmful, discriminatory and based upon a flawed
understanding of market dynamics. More fundamentally, the WMBAA
believes that this disparity is inconsistent with the provisions of
Section 2(h)(1)(B) of the Commodity Exchange Act.
The WMBAA also believes that eliminating the disparity described
above is consistent with the competitive landscape that Congress
intended to establish for SEFs and DCMs. Dodd-Frank is designed to
encourage competition between SEFs and DCMs with respect to the trading
of swaps, in part by rejecting the ``vertical silo'' model that has
traditionally been employed in the futures markets.
Interim or Temporary SEF Registration
The implementation of any interim or temporary registration relief
must be in place for registered trading systems or platforms at the
time that swaps are deemed ``clearable'' by the Commissions to allow
such platforms to execute transactions at the time that trades begin to
be cleared. Interim or temporary registration relief would be necessary
for trading systems or platforms if sequencing of rules first addresses
reporting to SDRs and mandatory clearing prior to the mandatory trade
execution requirement. The Commission is strongly encouraged to provide
prompt provisional registration to existing trade execution
intermediaries that intend to register as a SEF and express intent to
meet the regulatory requirements within a predetermined time period. To
require clearing of swaps through derivatives clearing organizations
without the existence of the corresponding competitive trade execution
venues risks inconsistent implementation of the Dodd-Frank Act and
could have a disruptive impact on market activity and liquidity
formation, to the detriment of market participants.
At the same time, a temporary registration regime should ensure
that trade execution on SEFs and exchanges is in place without
benefiting one execution platform over another. Temporary registration
for existing trade execution platforms should be fashioned into final
rules in order to avoid disrupting market activity and provide a
framework for compliance with the new rules. The failure of the
Commissions to provide interim or temporary relief for existing trading
systems or platforms may alter the swaps markets and unfairly induce
market participants to trade outside the U.S. or on already registered
and operating exchanges.
The 15 Second Rule
There does not appear to be any authority for the CFTC's proposed
requirement that, for ``Required Transactions,'' SEFs must require that
traders with the ability to execute against a customer's order or
execute two customers against each other be subject to a 15 second
timing delay between the entry of those two orders (15 Second Rule).
One adverse impact of the proposed 15 Second Rule is that the dealer
will not know until the expiration of 15 seconds whether it will have
completed both sides of the trade or whether another market participant
will have taken one side. Therefore, at the time of receiving the
customer order, the dealer has no way of knowing whether it will
ultimately serve as its customer's principal counterparty or merely as
its executing agent. The result will be greater uncertainly for the
dealer in the use of its capital and, possibly, the reduction of dealer
activities leading, in turn, to diminished liquidity in and
competitiveness of U.S. markets with costly implications for buy-side
customers and end users.
While this delay is intended by the CFTC to ensure sufficient
pretrade transparency, under the CEA, transparency must be balanced
against the liquidity needs of the market. Once a trade is completed
when there is agreement between the parties on price and terms, any
delay exposing the parties to that trade to further market risk will
have to be reflected in the pricing of the transaction, to the
detriment of all market participants.
Ensuring That Block Trade Thresholds Are Appropriately Established
The most important aspect to ensuring that appropriate block sizes
are set, is for the Commission to integrate the new reporting
requirements first, and than establish block trade thresholds based on
the comprehensive and reliable market data produced from these
reporting requirements. From the perspective of intermediaries who
broker transactions of significant size between financial institutions,
it is critical that the block trade threshold levels and the reporting
regimes related to those transactions are established in a manner that
does not impede liquidity formation. A failure to effectively implement
block trading thresholds will frustrate companies' ability to hedge
commercial risk. Participants rely on swaps to appropriately plan for
the future, and any significant changes to market structure might
ultimately inhibit economic growth and competitiveness.
Establishing the appropriate block trade thresholds is of
particular concern for expectant SEFs because the CFTC's proposal
regarding permitted modes of execution restricts the use of voice-based
systems solely for block trades. While WMBAA believes that this
approach is contrary to the SEF definition (as discussed above), which
permits trade execution through any means of interstate commerce, this
approach, if combined with block trade thresholds that are too high for
the particular instrument, would have a negative impact on liquidity
formation.
With respect to block trade thresholds, the liquidity of a market
for a particular financial product or instrument depends on several
factors, including the parameters of the particular instrument,
including tenor and duration, the number of market participants and
facilitators of liquidity, the degree of standardization of instrument
terms and the volume of trading activity. Compared to commoditized,
exchange-traded products and the more standardized OTC instruments,
many swaps markets feature a broader array of less-commoditized
products and larger-sized orders that are traded by fewer
counterparties, almost all of which are institutional and not retail.
Trading in these markets is characterized by variable or noncontinuous
liquidity. Such liquidity can be episodic, with liquidity peaks and
troughs that can be seasonal (e.g., certain energy products) or more
volatile and tied to external market and economic conditions (e.g.,
many credit, energy, and interest rate products).
As a result of the episodic nature of liquidity in certain swaps
markets combined with the presence of fewer participants, I and my
fellow WMBAA members believe that the CFTC and SEC need to carefully
structure a clearing, trade execution and reporting regime for block
trades that is not a ``one size fits all'' approach, but rather takes
into account the unique challenges of fostering liquidity in the broad
range of swaps markets. Such a regime would provide an approach that
permits the execution of transactions of significant size in a manner
that retains incentives for market participants to provide liquidity
and capital without creating opportunities for front-running and market
distortion.
To that end, we support the creation of a Swaps Standards Advisory
Committee (Advisory Committee) for each Commission, comprised of
recognized industry experts and representatives of registered SDRs and
SEFs to make recommendations to the Commissions for appropriate block
trade thresholds for swaps. The Advisory Committee would (1) provide
the Commissions with meaningful statistics and metrics from a broad
range of contract markets, SDRs and SEFs to be considered in any
ongoing rulemakings in this area and (2) work with the Commissions to
establish and maintain written policies and procedures for calculating
and publicizing block trade thresholds for all swaps reported to the
registered SDR in accordance with the criteria and formula for
determining block size specified by the Commissions.
The Advisory Committee would also undertake market studies and
research at its expense as is necessary to establish such standards.
This arrangement would permit SEFs, as the entities most closely
related to block trade execution, to provide essential input into the
Commissions' block trade determinations and work with registered SDRs
to distribute the resulting threshold levels to SEFs. Further, the
proposed regulatory structure would reduce the burden on SDRs, remove
the possibility of miscommunication between SDRs and SEFs and ensure
that SEFs do not rely upon dated or incorrect block trade thresholds in
their trade execution activities. In fact, WMBAA members possess
historical data for their segment of the OTC swap market which could be
analyzed immediately, even before final rules are implemented, to
determine appropriate introductory block trade thresholds, which could
be revised after an interim period, as appropriate.
5. Wholesale Brokers, CROs, and the Responsible Oversight of SEFs
The WMBAA members look forward to performing our designated roles
as SEFs under DFA. The wholesale brokerage industry is working hard and
collaboratively with the two Commissions to inform and comment on
proposed rules to implement DFA. The WMBAA has submitted several
comment letters \7\ and expects to provide further written comments to
the CFTC and SEC. The WMBAA has also hosted the first conference,
SEFCON 1, \8\ dedicated specifically to SEFs, and is currently making
arrangements for a second SEFCON later this year. Further, the WMBAA
has conducted numerous meetings with Commissioners and staffs. We and
the wholesale brokerage industry are determined to play a constructive
role in helping the SEC and the CFTC to get the new regulations under
Title VII of DFA right.
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\7\ See, Comment Letter from WMBAA (November 19, 2010) (11/19/10
WMBAA Letter); Comment Letter from WMBAA (November 30, 2010) (11/30/
2010 WMBAA Letter); 1/18/11 WMBAA Letter; Comment Letter from WMBAA
(February 7, 2011) (2/7/11 WMBAA Letter); and Comment Letter from WMBAA
(June 3, 2011) (6/3/11 WMBAA Letter).
\8\ SEFCON 1 was held in Washington, DC, on October 4, 2010. The
keynote address was given by CFTC Commissioner Gary Gensler.
---------------------------------------------------------------------------
It is clear, however, that the implementation of Dodd-Frank will
create a host of new obligations for both SEFs and regulatory agencies.
These include requirements that are typical for exchanges and self-
regulatory organizations, such as requirements to (1) establish,
investigate, and enforce rules; and (2) monitor trading and obtain
information necessary to prevent manipulation.
Many likely SEFs are not currently regulated as exchanges, but
rather as futures commission merchants (FCMs), broker-dealers or, where
applicable, as alternative trading systems (ATS). As a result, these
entities have familiarity with the rules of one or more self-regulatory
organizations, such as FINRA or the NFA, which together with the
Commission and the CFTC, will perform many of the regulatory functions
assigned by the Dodd-Frank Act to SEFs.
In order to facilitate the development and success of SEFs, the
WMBAA proposes the establishment of a CRO that will facilitate all SEFs
compliance with the core principles. Membership in the CRO would be
voluntary and open to any entity intending to register as SEF, though
member SEFs would be contractually bound to abide by the rules.
Further, as a voluntary organization, the CRO would not necessarily
need legislative or rulemaking authority to proceed. The creation of a
CRO would also prevent market participants from selectively choosing
which SEF to use based upon the leniency of its rules regime. The WMBAA
believes that an industry-wide standards body would best ensure the
integrity of the swaps market and protect market participants from
abusive trading practices. Moreover, by acting as an intermediary for
compliance by its members, the CRO would simplify the CFTC's and SEC's
oversight responsibilities for SEFs.
Conclusion
Dodd-Frank seeks to reengineer the U.S. swaps market on three key
pillars: record keeping and reporting; central counterparty clearing;
and the mandatory intermediation of clearable trades through registered
intermediaries such as SEFs. Wholesale brokers are today's central
marketplaces in the global swaps markets and, as such, can be the
prototype of SEFs.
Liquidity in today's swaps markets is fundamentally different than
liquidity in futures and equities markets and naturally determines the
optimal mode of market transparency and trade execution. Wholesale
brokers are experts in fostering liquidity in noncommoditized
instruments by utilizing methodologies for price dissemination and
trade execution that feature a hybrid blend of knowledgeable qualified
voice brokers and sophisticated electronic technology. Wholesale
brokers' varied execution methodologies are specifically tailored to
the unique liquidity characteristics of particular swaps markets.
It is critical that regulators gain a thorough understanding of the
many modes of swaps trade execution currently deployed by wholesale
brokers and accommodate those methods and practices in their SEF
rulemaking. Too many of the SEC's and CFTC's Title VII proposals are
based off of rules governing the equities and futures markets and are
ill-suited for the fundamentally different liquidity characteristics of
today's swaps markets.
We appreciate the Commissions' recognition of the deliberation and
thought necessary to get these rules right, and are generally
supportive of the phase-in approach being pursued. Rushing the
rulemaking process and getting things wrong will negatively impact
market liquidity in the U.S. swaps markets, disturbing businesses'
ability to hedge commercial risk, to appropriately plan for the future
and, ultimately, stifle economic growth and job creation. Taking
adequate time to get the Title VII regulations right will expedite the
implementation of the worthy goals of Dodd-Frank: central counterparty
clearing and effective trade execution by regulated intermediaries in
order to provide end users with more competitive pricing, increased
transparency and deeper trading liquidity for their risk management
needs.
With Congress' help, and the input and support of the swaps
industry, regulators can continue their dedicated efforts at well-
crafted rulemaking. If we are successful, our U.S. financial system,
including the U.S. swaps markets, can once again be the well ordered
marketplace where the world comes to trade.
Thank you for your consideration. I look forward to answering any
questions that you may have.
______
PREPARED STATEMENT OF CHRIS BURY
Cohead of Rates Sales and Trading, Jefferies & Company, Inc.
June 29, 2011
Good morning. My name is Chris Bury and I am the Cohead of Rates
Sales and Trading for Jefferies & Company, Inc. Chairman Reed and
Ranking Member Crapo, thank you for inviting me to testify this morning
regarding the emergence of swap execution facilities or, as they have
come to be known, SEFs.
Jefferies is a full-service global securities and investment-
banking firm that, for almost 50 years, has been serving issuers and
investors. We provide investment banking, and research sales-and-
trading services and products to a diverse range of corporate clients,
Government entities, institutional investors and high net worth
individuals. The last few years have been a pivotal time for Jefferies
as we gained market share and built significant momentum by
capitalizing on strategic opportunities to expand and diversify on
multiple levels and across all business lines. Over the last 5 years,
our firm's annual revenue, equity market capitalization and global
headcount have increased significantly, with now almost $3 billion in
annualized net revenue, over $4 billion in equity market value, and
soon-to-be 3,600 employees.
It bears noting that during that same period--that is, during the
financial crisis--at no time did Jefferies seek or receive taxpayer
assistance. As a publicly traded company on the New York Stock
Exchange, our capital comes solely from the markets, and Jefferies'
ability to persevere and emerge from the financial crisis positioned
for growth and diversification can best be attributed to the firm's
focus on a strong capital position, ample liquidity, and sound risk
management.
There are a few key points that Jefferies would like to convey to
the Subcommittee:
First, we are ready to go. From our perspective, the
architecture, infrastructure and technology necessary to bring
the over-the-counter derivatives markets into an era of
transparency, dispersed counterparty risk and open access are
in place. Just as we are a leading provider of liquidity and
execution in stock and bonds, we believe we can become a
leading provider to buyers and sellers of derivatives. The
market awaits the adoption of final rules--it is a fallacy to
suggest that rules should be delayed to allow more time for
this market structure to develop.
Second, we believe that those sections of Title VII of
Dodd-Frank pertaining to SEF trading of derivatives are
necessary to remedy the artificial barriers to entry in the OTC
derivatives market. It is with the intention of enhancing
market participation and fostering competition that we support
prompt implementation of these requirements.
Third, implementation timelines should be the top priority
at this juncture. The proposed rules are generally clear and
understandable. The market needs the certainty of when the
rules will become applicable far more than it needs any more
suggestions about how bilateral agreements offer an alternative
to central clearing.
Fourth, it is vitally important to guard against the
development of market structures that enable opaque bilateral
contract relationships to continue to exist. Current
standardized-execution-agreement proposals for centrally
cleared swaps do nothing but preserve the closed and
anticompetitive elements of these markets as they existed prior
to the financial crisis.
Fifth, the adoption of the rules and a clear timeline for
implementation of Title VII will bring to the markets the same
clear benefits gained from similar developments in equities and
futures markets: increased access, expanded competition,
improved price transparency, and decentralized risk. SEF
trading will lead to lower transaction costs, greater
liquidity, strengthened market structures and reduced implicit
risks to market participants and the American taxpayer.
For years, firms such as Jefferies were effectively locked out of
being a dealer in the OTC markets by virtue of a series of artificial
barriers and requirements that perpetuated a closed system. Market
participants were reliant upon bilateral contract arrangements with a
self-selected group of large interconnected banks, dealers and
insurers. The weaknesses and lack of true competition of that closed
system exacerbated the credit crisis of 2008 to the great expense of
our economy. We support the implementation of SEF trading as quickly
and responsibly as possible. We believe that these provisions will
increase transparency, reduce systemic risk, increase competition, and
broaden access to centralized clearing within the derivatives market
place.
From our perspective, the development of the SEF market and access
to SEFs are fairly straightforward. In addition, the rules as jointly
proposed by the Commodity Futures Trading Commission and Securities and
Exchange Commission with regard to mandatory exchange or SEF trading
are clear.
Jefferies' main concern, therefore, is not centered around a lack
of understanding of the rules, nor around the notion that the rules are
being implemented before the SEF market has developed. Quite to the
contrary: Jefferies is concerned that a rule delay is one of the
biggest risks facing this emerging SEF marketplace today. We believe
the market will successfully transition to SEF trading once a timeline
is established in terms of what types of swaps will be required to
transact on a SEF.
Another risk to the development of the cleared derivatives market
is the potential for the handful of too-big-to-fail banks that were
bailed out by taxpayers to undermine and delay implementation of
derivatives reform. We believe that recent suggestions from those banks
regarding alternative documentation and workflow issues are nothing
more than an effort to stifle competition and maintain the status quo.
We believe that the concern over these workflow issues and ``what-
if'' scenarios will rapidly fade once the scale and scope of the
technological investment in SEFs and a centrally cleared derivatives
marketplace is better understood. Significant technological, financial
and intellectual resources have been committed by a wide variety of
market participants to get SEFs up and running as quickly as possible.
Those investments have paid off, as the Financial Times noted last
month in its special report on derivatives: ``[T]he main participants,
banks, interdealer brokers and `big end users' are ready to go when it
comes to electronic trading and clearing.'' (Financial Times Special
Report, May 31, 2011, as quoted in SDMA Letter to CFTC and SEC dated
June 1, 2011.)
The article went on to note that SEF-compliant trades between swap
dealers and major swap participants have been reported on Javelin,
TradeWeb, MarketAxess, and Bloomberg in both interest rate swap and
credit default swap products.
Our industry is, indeed, approaching full readiness for
standardized OTC derivatives contracts to begin trading on SEFs. If the
proposed rules are implemented by the end of 2011, Jefferies would
anticipate that trading volumes will begin increasing by the fourth
quarter of this year and then increase significantly into 2012 as we
approach final implementation of mandatory SEF trading of standardized
derivatives. A firm timeline for mandatory SEF trading of the most
standardized swaps will be instrumental for the market to achieve its
full potential.
More importantly, delaying the implementation process will provide
opportunities for entrenched interests to promote agreements that will
degrade and deter free market forces from operating in the derivatives
arena. The recently released Futures Industry Association (FIA) Cleared
Swap Agreement is one such example. Although it is marketed as an
industry-wide document developed by a variety of market participants,
we are concerned that the published version, were it broadly adopted by
market participants, would embed chokepoints into the system. Customer
agreements that provide for either fallback provisions to bilateral
relationships or workflows that require complicated credit limit
checking arrangements, as the current FIA offering proposes, will not
foster a fully transparent, open, and competitive market. Congress and
the regulators should encourage market participants to adopt agreements
and market frameworks that provide for immediate certainty of clearing
in order to advance the open access provisions and central clearing
mandate of Dodd-Frank.
Conclusion
Jefferies believes that implementation of Title VII reforms will
unleash free market forces held in check by entrenched business models,
and we are ready and eager to compete in the derivative marketplace.
Thank you for inviting me to testify today, and I look forward to any
questions the Subcommittee may have.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR TOOMEY
FROM KEVIN McPARTLAND
Q.1. The reporting requirements that the CFTC/SEC has proposed
for all SEFs transactions will require virtual real-time
reporting of key transaction data. Won't liquidity providers
(i.e., dealers) increase their bid/ask spreads to reflect the
increased risks associated with communicating key data to the
marketplace (since dealers will not be able to hedge these
positions before they are front-run)? In order to justify this
risk, won't liquidity providers necessarily pass these
increased costs to end users? In your view, does moving to SEFs
justify these increased costs and reduced liquidity?
A.1. In the most liquid products reporting requirements will be
of little long term consequence. To those in the market
already, pricing data is in fact quite transparent and so
additional dissemination will have little impact on spreads.
For less liquid products however, it is very likely that a risk
premium will now be embedded in the quoted price. However, even
in today's market brokers often hedge new positions using other
instruments such as futures and bonds to avoid being ``picked
off'' by other market participants who are aware a trade just
took place. This approach will become more prevalent in the new
world.
It is important to note however that as the market becomes
more electronic and more efficient, new liquidity providers
will emerge to keep the prices between futures, bonds, and
swaps very closely aligned. This will only make it easier to
hedge a new swap position elsewhere with little market impact.
Q.2. The CFTC's proposed SEFs rules would require that market
participants put out a minimum of five Requests for Quotes
before they complete a transaction. Given that most of the OTC
market currently trades in a nonstandardized form, wouldn't
this requirement to garner five RFQs cause participants to
share important information to the marketplace, which the
market could use against that participant? In other words,
wouldn't this requirement to trade with the RFQ model increase
bid/ask spread for end users and potentially increase
volatility?
A.2. It is first important to note that the majority of trading
in interest rate swaps and credit default swaps occurs on
standardized contracts. Vanilla U.S. Dollar interest rate swaps
of standard durations (2 yr., 5 yr., 7 yr., 10 yr., 30 yr.) and
index credit default swaps are in fact viewed as quite liquid
by market participants. TABB Group's conversations with buy
side traders, bulge bracket swaps dealers and midsized swaps
dealers confirm this point.
That all said, these same market participants all believe
that requiring an RFQ to be sent to five market participants
would in fact widen spreads, decrease liquidity and drive
trading to other products that did not have the same
requirement. TABB Group believes that five is an arbitrary
number and one that is not supported by historical precedent in
this or any other financial market. Yet although we firmly
believe a principles based approach to SEF regulation, one in
which they are free to compete with each other based solely on
their merits is best, in keeping with the goals of Dodd-Frank
changing the RFQ requirement to read ``more than one'' would
act as a reasonable compromise that would not impact the
majority of RFQ trades done today.
Q.3. If the CFTC defines the size of a ``block trade'' too
narrowly, then very few trades will be permitted off the SEFs.
Given that most of the interest rate and credit default swaps
trade in blocks too small to qualify as ``blocks'' under the
new rules, wouldn't a phased-in approach be more appropriate
than a cold-turkey move to the various SEFs rules? With regard
to the CFTC's block rules, does the CFTC's one-size-fits-all
approach make sense? Not all swaps have the same risk
characteristics and lumping all interest rate swaps into one
bucket for blocks (and similarly for CDS) does not seem
consistent with market convention.
A.3. Setting the block trade size as a multiple of the current
average trade size is unreasonable. The majority of swaps
trades done today are in fact block trades. The average size of
an interest rate swap is $129 million--but that is because much
of the trading in this market is done by financial and
commercial end users hedging real positions. That is in stark
contrast to the highly electronic futures market where most
market participants are looking for short term exposure to a
particular reference entity. One can reasonably conclude that
once the vanilla interest rate swap market is centrally cleared
and traded electronically the average trade size could decrease
by a factor of ten. That said, block sizes must be forward
looking and take into account how these products are used and
by whom.
Q.4. Do you envision that block trades will be treated
differently by SEFs versus DCMs? If so, how and why?
A.4. Block trade rules are and should be focused on reporting
and not on method of execution. As stated in our testimony,
TABB Group strongly believes a principals based approach is
best for the swap execution space allowing SEFs and DCMs alike
to compete for liquidity based on trading mechanisms provided,
price, technology and other competitive factors. That said, the
time delay for reporting a block trade as well as the size of a
block trade must be consistent regardless of where a trade is
done. If one venue sets the block size lower than another we
will quickly see liquidity move to the venue with the lower
threshold. So ultimately, execution method should be left open
to the venue but the block definition must be consistent
systemwide.
Q.5. The margin calculation for SEFs (which requires a minimum
5-day liquidation period) v. DCMs (1-day liquidation period)
has a significant impact on required margin. Why were these
arbitrary liquidation periods established?
A.5. Market convention uses liquidation periods of between 1
and 10 days. 5-day liquidation is not uncommon. The liquidation
period used to calculate margin is influenced by liquidity. The
lower expected or perceived liquidity of an instrument, the
wider the liquidation period (up to 10 days.) But since margin
can be changed often, it is not critical to fixate on a
particular look-back period as long as it is in the acceptable
range. Furthermore, it makes sense that margin levels for newly
clearable products would start out at a conservative point.
The longer the duration of a contract the greater the risk
to the clearinghouse. As swaps tend to be of much longer
duration (the 10-year interest rate swap is one of the most
common) as compared to futures (often 3-6 months) the risk and
hence the margin requirements are greater for swaps. TABB Group
research has found that on the short end of the curve margin
levels are in fact quite similar for swaps and futures. But as
duration increases the gap widens considerably.
Q.6. We understand the CFTC is considering a different
segregation regime for customer margin for SEFs v. DCMs. Why?
What is the benefit?
A.6. Independent of the vernacular, there are two margin
segregation schemes being contemplated. One is like the futures
markets where customer funds are comingled in an omnibus
account of the clearing member. The problem with this structure
is that customers do not want to have exposure to one another
for OTC derivative trades. The other segregation method is
described as legally separated but operationally comingled.
This format is intended to provide the margin benefits of the
futures model without the exposure to defaulting parties.
In all cases, the benefit of pooling more margin funds is
that it gives the clearinghouse the potential to offer margin
offsets between more products, such futures and swaps (which
are often used to hedge one another). In short, fund
segregation regimes can determine the level of margin offsets
(offered to spread products), and margin offsets are the
primary key to lowering and ultimately minimizing the oncoming
burdens of initial margin requirements for OTC derivatives.
Q.7. Why do the proposed SEF rules not allow for derivatives
voice trading?
A.7. Yes, and they should. Swap transactions are often complex
and very large. Following TABB Group conversations with real
money buy side accounts, it became quite clear that the ability
to speak with a broker is critical in the trading process for
many. As a case in point, there is a reason why your average
retail investor is still willing to pay $50 per trade to call
in an order even though trading online is available for under
$10 per trade. That said, we firmly believe that even for
transactions discussed over the phone prompt entry into an
execution platform for reporting purposes is critical to the
ultimately transparency and success of the swaps market going
forward.
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RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM NEAL B. BRADY
Q.1. A number of participants have expressed concern about a
potential lag between execution and clearing that could leave
counterparties exposed to a trade that will be eventually
unwound. Mr. Brady, in your testimony, you state that this
concern ``is exaggerated.'' Would you go into more detail on
your views regarding swap trades that fail to clear or so-
called clearing ``fails''?
A.1. Eris Exchange believes that concern about ``fails'' on
SEFs is exaggerated and addressable by applying a futures
industry solution that has been in place for a long time;
namely, pretrade credit checks and credit guarantees at the
clearing firm level. By applying pretrade credit checks, the
futures market model avoids the complexity of resolving post-
trade operational issues that could result in a ``fail.'' In
addition, by applying pretrade credit checks, the futures
market model ``prequalifies'' individual participants to trade
with each other as long as each participant is guaranteed by a
registered clearing firm. This market model vastly simplifies
documentation requirements for end users, eliminates the need
for end users to enter into complex trilateral agreements,
greatly expands access, and allows end users to transact
cleared swaps while preserving anonymity.
Under the futures market model, and, specifically, at Eris
Exchange, clearing firms manage and administer pretrade credit
checks themselves, and therefore there is no risk of trade
rejection at the Clearinghouse due to insufficient credit or
any other post-trade operational issue. The acceptance of a
trade by the Clearinghouse occurs in milliseconds. Importantly,
in the futures market model, executing brokers are also
guaranteed by their primary clearing firm. Thus, at every point
in the execution chain, a clearing member stands behind every
futures contract trade.
If SEFs were to conform more closely to the futures
industry model, this would alleviate the need for end users on
SEFs to enter into complicated trilateral documentation
negotiations and would also address another significant concern
raised by major buy side participants--end users' desire not to
reveal their identity--to remain anonymous--during the
execution process.
In the futures exchange model and at Eris Exchange, each
participant enters into a single agreement totaling two pages
with a clearing firm, one time, and then the participant is
eligible to trade, anonymously, with any other participant
backed by any other registered clearing firm.
In sum, the futures model: (1) does not subject end users
to ``trade uncertainty'' and the potential for ``fails''; (2)
greatly streamlines the documentation process; (3) opens up
access to a much wider and diversified range of market
participants; and (4) preserves anonymity during the trade
process, therefore ensuring the most competitive and cost
effective execution for end users.
The CFTC has recently proposed rules in response to the
``fails'' and documentation debate that applies the futures
exchange model to the execution of swaps. See, 76 FR 45724
(Clearing Member Risk Management) and 76 FR 45730 (Customer
Clearing Documentation and Timing of Acceptance for Clearing).
The proposed rulemaking on clearing member risk management
would, among other things, require swap dealers, major swap
participants, and futures commission merchants that are
clearing members to use automated means to screen orders for
compliance with the risk-based limits. The proposed rulemaking
on customer clearing documentation and timing of acceptance for
clearing would, among other things permit derivatives clearing
organizations (DCOs) to screen trades against applicable
product and credit criteria before accepting or rejecting them
``as quickly as would be technologically practicable if fully
automated systems were used.'' Eris Exchange is supportive of
these proposed rules for the reasons set forth above, as well
as in the Exchange's testimony.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR TOOMEY
FROM NEAL B. BRADY
Q.1. The reporting requirements that the CFTC/SEC has proposed
for all SEFs transactions will require virtual real-time
reporting of key transaction data. Won't liquidity providers
(i.e., dealers) increase their bid/ask spreads to reflect the
increased risks associated with communicating key data to the
marketplace (since dealers will not be able to hedge these
positions before they are front-run)? In order to justify this
risk, won't liquidity providers necessarily pass these
increased costs to end users? In your view, does moving to SEFs
justify these increased costs and reduced liquidity?
A.1. Eris Exchange strongly disagrees with the assumption
embedded in the question above--that price transparency and
real-time reporting leads to increased costs for end users. To
the contrary, price transparency decreases end users' execution
costs.
As has been empirically shown in cash Treasury markets,
Treasury futures markets, Eurodollar futures markets, and a
host of other asset classes that have evolved to screen-based
trading, real-time reporting leads to narrower bid/ask spreads,
greater price transparency, and therefore decreased costs for
end users. Real-time reporting also leads to deeper liquidity
from a more diversified pool of liquidity providers, and
therefore spreads trading inventory across a broader range of
counterparties, which decreases systemic risk. Furthermore,
real-time price reporting substantially decreases systemic risk
by providing clearinghouses, regulators, clearing firms and end
user participants with the trade information necessary to
monitor and manage intraday risk.
As for the concern about ``front running'' of liquidity
provider hedges, this is best addressed by an appropriate and
flexible block trading requirement. The futures market is a
great example of how bilateral block trades and a transparent
Central Limit Order Book (CLOB) can exist and thrive operating
side-by-side. In the futures markets, all trades below the
block threshold are transacted centrally, and prices are
reported instantaneously. Above the block trade threshold,
where end user trades are large enough that liquidity providers
have a legitimate concern about being ``front run'' on their
hedges, market participants are allowed to transact
bilaterally, and report these trades within an exchange-defined
time limit. This framework has worked extremely well in the
futures markets for many decades and has led to much tighter,
rather than wider, bid-ask spreads. In other words, the
efficiencies in the transparent, yet flexible, futures industry
marketplace have allowed liquidity providers to pass on lower
execution costs to end user clients.
While certain flexibilities for block trades are
appropriate, such rules must be balanced with the harm that can
result from too many block trades. Specifically, an excessive
number of block trades in a given market can impact the quality
of the markets offered in the CLOB. In a market that has
excessive block trading, liquidity providers active in the CLOB
are forced to make markets without access to critical price
information. In addition, many of the trades that come into the
CLOB are simply hedging activity resulting from block trades
that have occurred outside the centralized market. In this
market scenario, liquidity providers in the CLOB are forced to
widen their bid/ask, which in turn results in more block
trades.
Given the potential for harm to the CLOB of excessive block
trading, it is important to set block trade thresholds high
enough so that the only block trades permitted are those that
would have otherwise materially impacted the market. The CFTC's
proposed rule for futures block trades on designated contract
markets (DCMs) provides guidance on how block size should be
determined, including that the acceptable ``minimum block trade
size should be a number larger than the size at which a single
buy or sell order is customarily able to be filled in its
entirety in that product's centralized market without incurring
a substantial price concession.'' See, 75 FR 80572, 80630
(Acceptable practices for block size determination).
Q.2. The CFTC's proposed SEFs rules would require that market
participants put out a minimum of five Requests for Quotes
before they complete a transaction. Given that most of the OTC
market currently trades in a nonstandardized form, wouldn't
this requirement to garner five RFQs cause participants to
share important information to the marketplace, which the
market could use against that participant? In other words,
wouldn't this requirement to trade with the RFQ model increase
bid/ask spread for end users and potentially increase
volatility?
A.2. When discussing the issue of appropriate market protocols,
it is important to distinguish between standardized (liquid)
products and nonstandardized (illiquid) products. Eris Exchange
is live and operational today in a very liquid and standardized
market for vanilla interest rate swaps derivatives.
For highly liquid and standardized markets like markets in
``plain vanilla'' interest rate products, which is estimated to
account for more than 50 percent of OTC turnover, swaps or
futures equivalents can be readily traded with a ``5 RFQ''
protocol, as well as a CLOB. Specifically, at Eris Exchange,
which has applied to become a DCM, trades in the Eris interest
rate swap futures contract can only be done via either the CLOB
or an RFQ that initiates an all-to-all central limit order
book. While some may view this DCM requirement for transparency
as a deterrent for liquidity providers to publish tight bid-
ask, the empirical evidence points to the contrary:
transparency, open access, and protocols that create a level
playing field for competition have historically resulted in
lower costs for end users. For DCOs, transparency also means
there will be ample data available that is necessary for
valuing and settling contracts, which ultimately allows for
lower margin and better management in default situations. And,
finally, for regulators, transparency means better monitoring
of the marketplace.
While a CLOB represents the most developed trading
platform, Eris Exchange believes that in this time of
transition, ``principles-based'' regulation--meaning the
Commission provides concepts for compliance with the Act--will
permit SEFs with the flexibility to comply with the Act.
As for nonstandardized products, there is still question as
to whether or not such products will be subject to the clearing
mandate.
Q.3. If the CFTC defines the size of a ``block trade'' too
narrowly, then very few trades will be permitted off the SEFs.
Given that most of the interest rate and credit default swaps
trade in blocks too small to qualify as ``blocks'' under the
new rules, wouldn't a phased-in approach be more appropriate
than a cold-turkey move to the various SEFs rules? With regard
to the CFTC's block rules, does the CFTC's one-size-fits-all
approach make sense? Not all swaps have the same risk
characteristics and lumping all interest rate swaps into one
bucket for blocks (and similarly for CDS) does not seem
consistent with market convention.
A.3. As was stated in the Exchange's testimony, Eris Exchange
believes that (1) a one-size-fits-all approach to block trading
rules does not make sense and (2) a principles-based approach
works best. The principles-based approach to block trading
limits has worked extremely well in the futures industry where
DCMs determine their block trading rules.
The challenge the CFTC and the industry faces is that there
will be multiple SEFs offering the execution of the same swap,
so there should be consistency across SEFs. The CFTC addresses
this challenge by including a proposed rule that requires Swap
Data Repositories to set block trading sizes based on a
prescribed formula. Instead of this prescriptive approach, the
CFTC should consider having the SDRs use a principles-based
approach to set block sizes, which will eliminate the need for
a phased-in approach. The Commission can then periodically
review the block trade thresholds and require SEFs to raise or
lower these thresholds depending on how the market evolves.
As we also stated in our opening statement and in response
to questions during the hearing, Eris Exchange believes that
each asset class is unique and should have block limits that
are tailored and appropriate for that particular asset class.
Lumping interest rate swaps and CDS into a single bucket and
treating these assets classes the same with regard to blocks is
not consistent with market convention.
Q.4. Do you envision that block trades will be treated
differently by SEFs versus DCMs? If so, how and why?
A.4. Eris Exchange believes that the Commission intentionally
differentiated between the regulatory treatment of SEFs and
DCMs. Specifically, SEFs and DCMs are held to very different
standards of price transparency for swaps trades below the
block trade threshold and therefore it makes sense to
differentiate with respect to block trade thresholds and
reporting requirements for swaps in these two very different
types of markets.
Q.5. The margin calculation for SEFs (which requires a minimum
5-day liquidation period) v. DCMs (1-day liquidation period)
has a significant impact on required margin. Why were these
arbitrary liquidation periods established?
A.5. Eris Exchange does not believe that these proposed
liquidation periods are arbitrary; rather, in proposing the
rules related to minimum 5-day VaR for a SEF and 1-day VaR for
a DCM, the CFTC clearly recognized the important distinction
between executing trades on a DCM, as opposed to on a SEF.
Specifically, DCMs are held to a higher standard of price
transparency (i.e., a CLOB) and therefore, should be allowed to
receive margining treatment more akin to standardized futures
markets than to SEF markets with more opaque execution methods.
Given the execution standards for a DCM, the DCO can better
ensure a liquidation time due to the active CLOB trading on a
DCM. The DCM, anonymous CLOB model allows participants to trade
in and out of products in a cost-effective and time-effective
manner. The Exchange believes that the transparency of a CLOB-
driven DCM swaps market is a very valuable addition to the post
Dodd-Frank marketplace and a clear example of some of the
benefits that will be delivered to end user clients as a result
of the regulatory reform.
Q.6. We understand the CFTC is considering a different
segregation regime for customer margin for SEFs v. DCMs. Why?
What is the benefit?
A.6. As a futures market, Eris Exchange contracts will be
placed in the traditional futures account, the 4d account. It
is worth noting that the CFTC has proposed using different
segregation regimes for swaps regardless of whether the
transaction is executed on a SEF or DCM. Therefore, if a DCM
offers the trading of futures and swaps, it is possible that a
given client's futures contracts will be in one account for
futures (i.e., Futures or Baseline Model) and a different
account for swaps (e.g., Complete Legal Segregation Model).
In general, Eris Exchange operates under a futures
margining framework and believes that this framework has worked
extremely well for the futures industry.
Q.7. Why do the proposed SEF rules not allow for derivatives
voice trading?
A.7. The proposed SEF rules do provide a role for voice
trading; however, the proposed rules balance this role with the
transparency requirements of the Dodd-Frank Act. As discussed
in the CFTC's proposal:
While not acceptable as the sole method of execution of
swaps required to be traded on a SEF or DCM, the
Commission believes voice would be appropriate for a
market participant to communicate a message to an
employee of the SEF, whether requests for quotes,
indications of interest, or firm quotes. For instance,
voice-based communications in the proposed SEF context
may occur in certain circumstances, such as when an
agent: (1) assists in executing a trade for a client,
immediately entering the terms of the trade into the
SEF's electronic system; or (2) enters a bid, offer or
request for quote immediately into a SEF's electronic
multiple-to-multiple trading system or platform. [76 FR
1214, 1221]
It is also important to note that voice trading is
permitted with regard to block trades or other ``permitted
Transactions'' as defined in the CFTC's SEF proposed rule. Id.
at 1241.
As an electronic futures exchange, Eris Exchange does not
permit voice trading to execute standard/nonblock trades.
However, the Exchange does have rules related to block trades,
which can be voice brokered.
Additional Material Supplied for the Record
STATEMENT SUBMITTED BY THE INVESTMENT COMPANY INSTITUTE
PAPER SUBMITTED BY THE INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION
LETTER SUBMITTED BY STEPHEN MERKEL, CHAIRMAN, WHOLESALE MARKETS
BROKERS' ASSOCIATION