Regulators Compromise on Swaps RFQ Rule, So Are the Banks Winning?

U.S. regulators finalized the rules for swap execution facilities (SEFs)yesterday, which are intended to bring transparency into the opaque derivatives market. But they also bowed to pressure from dealers to reduce a key requirement related to seeking derivatives prices from banks.

The compromise relates to how many banks a hedge fund or asset manager must contact (through the request for quote method) when seeking a derivatives price.

After the financial crisis, banks hired lobbyists who were fighting the requirement that hedge funds, asset managers and corporations had to contact at least five banks when seeking derivatives prices.

Under pressure from the banks as well as firms that buy derivatives, yesterday the agency agreed to reduce the number to two banks.

However, in about 15 months the standard will rise automatically to about three banks, though the agency will conduct a fact-based analysis of the RFQ minimum.

In an amendment to the core principles for swap execution facilities that was emailed to the media yesterday, the document reflects the commission’s views on the minimum RFQ.

“The three market participant requirement reflects the Commission’s current view that transmitting RFQs to only two market participants does not promote the statutory goal of pre-trade price transparency.”

However, the CFTC acknowledges that a phased implementation will assist market participants and SEFs in transitioning from the swap industry’s current bilateral market structure to the more transparent model. To provide market participants, SEFs and the swaps industry with time to adapt to the new transparent SEF regime, it’s phasing in the three participant requirement.

The compromise is also a response to market participants who wrote comment letters, including pension funds, end users and mortgage banks, such as Freddie Mac, who complained that a higher number of liquidity providers would raise transaction costs, wrote the CFTC in its amendment.

To address their concerns, one year from the compliance date of the SEF rules, the CFTC will assess impact of the RFQ of more than two requirement on trading liquidity of SEFs, the CFTC said. The CFTC said it would be able to make an informed evaluation because it will have individual SEF trading liquidity and aggregate trading liquidity from SEFs as well as data from swap data repositories.

Some critics of the status quo, including CFTC Chairman Gary Gensler, were pushing for five quotes to inject more competition into the swaps industry, noted today’s Wall Street Journal. However, other commissioners differed with Gensler.

According to The Wall Street Journal:

Commissioner Mark Wetjen, who supports the two trader minimum, said that the platforms would be "appropriately flexible." Wetjen objected to Mr. Gensler's insistence on five firms, citing industry concerns that information about trades could leak. Republican Commissioner Jill Sommers opposed the rule, saying the agency needed to analyze more data before acting.

The compromise is seen asa victory for the large Wall Street banks since the two- quote requirement will limit the amount of competitive quotes flowing through their electronic trading platforms. Five banks dominate the swaps market – J.P. Morgan, Bank of America, Citigroup, Morgan Stanley and Goldman Sachs Group, according to WSJ article citing data from the U.S. Comptroller of the Currency.

Despite the compromise, some industry advocates objected to several parts of the plan. Kenneth Bentsen, acting CEO of the Securities Industry Fnancial Markets Association (SIFA), said: "The CFTC's decision to impose a minimum bid requirement for certain swap transactions executed on SEFs will impair market liquidity at the expense of all market participants, ultimately harming the everyday investors that the rule aims to protect.

Even though Gensler agreed to soften the rules, the compromise still achieves the goal of moving the $700 trillion derivatives trading onto regulated electronic platforms, out of the shadows. While brokers will be able to negotiate voice trades via the phone, quotes will be posted on screens for the public to see.