At the ISDA DerivCon 2019 conference, three CFTC commissioners addressed recently proposed changes to rules relating to transacting on swap execution facilities ("SEFs"). (See previous coverage of the proposal here.)
CFTC Chair J. Christopher Giancarlo said that the existing framework creates systemic risks as, during a period of diminished liquidity, participants may withdraw from the swaps markets if they find the prescribed trading methods to be overly rigid. He criticized the existing SEF regulatory requirement as being "highly subjective" and overly reliant on a series of no-action letters and other staff interpretations. Nonetheless, he conceded that the proposals for change had been met with a good deal of justified criticism. In particular, Mr. Giancarlo indicated his willingness to reconsider aspects of the proposal relating to (i) the process for making a swap "available to trade" and (ii) requiring pre-trade communications to occur on SEFs. Mr. Giancarlo also indicated that the CFTC staff would be open to providing relief to a "meritorious request" as to the exclusion of "floor trader" activities from the scope of "swap dealing" activity. In response to concerns raised by Commissioner Dan M. Berkovitz as to concentration in the swaps dealing business, Mr. Giancarlo argued that the existing SEF rules have resulted in the concentration of swaps dealing, and suggested that this should lead regulators to reconsider the existing swaps rules.
Mr. Berkovitz criticized the proposal to overhaul the SEF rules, saying that the proposal would, among other things, (i) no longer ensure that SEFs enable market participants to "trade highly liquid standardized swaps with each other openly and competitively," (ii) allow SEFs to discriminate against classes of market participants, and (iii) increase prices for swap customers. Notwithstanding his criticism of the proposal, Mr. Berkovitz outlined four reforms he believes should be made to the existing CFTC rules relating to SEFs: (i) expanding floor trader registration, (ii) banning name give-up, (iii) permitting average pricing, and (iv) amending the application of the supplemental leverage ratio applicable to banks.
Commissioner Brian Quintenz lauded the proposal on the grounds that it would eliminate the current "made available to trade" process by which certain swaps are determined to be required to trade on an SEF. Mr. Quintenz expressed concern that the CFTC's decision to prescribe execution methods "substituted its judgment over the expertise and judgment of market professions and, more importantly, is not supported by the statute." Mr. Quintenz indicated, however, that he had heard criticism of the proposal's approach to pre-trade communications and the potential for it to disrupt existing bank-client trading relationships. He indicated that he did not believe this was the CFTC's intent, and expressed his interest in considering the views of commenters.
Commentary / Nihal Patel
The CFTC proposal relating to SEFs is wide-ranging and complex. It is difficult to view any particular aspect of the proposal in isolation. For example, considering the removal of an exception for block trades requires one to also consider the broader policy on pre-trade communications and the permissibility for market participants to execute trades through any means of "interstate commerce" as opposed to regulatory-mandated execution methods. Considering the more flexible methods of execution would then cause one to consider the much broader class of entities that will be required to register as SEFs. And so on. In short, the proposal is not so much a rule change as a regime change - it completely rethinks the way swaps trading is regulated.
In light of these complications, the debate at the CFTC (largely between Mr. Giancarlo and Mr. Berkovitz) is difficult to characterize. It seems to come down to beliefs as to regulatory philosophy. Mr. Giancarlo seems to take the view that the market will be best served by a (generally) more permissive rule set that will lead to greater innovation and flexibility. Mr. Berkovitz, on the other hand, seems to see an existing rule set that has served the market well and can be improved by more targeted changes.
Despite the philosophical differences, there is a great deal of similarity in many of the notes struck by Mr. Berkovitz and Mr. Giancarlo. Each seems to be in agreement as to changes to, among other things, the leverage ratio, the treatment of floor traders, the desire to address concentration in the swaps business, and the need to codify and clarify the patchwork of existing no-action letters and guidance. It seems reasonable to expect at least a handful of changes. The question that remains to be answered is whether the CFTC will seek to take a bolder approach over incrementalism when it comes to the remainder of the proposal.
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