November 15, 2010

The Commodity Futures Trading Commission is moving closer to issuing the preliminary rules defining swap execution facilities. This particular rulemaking will set the parameters for trading platforms for the over-the-counter derivative markets that will largely determine how transactions will be executed under the Dodd-Frank framework.

The CFTC has engaged in numerous discussions with market participants, soliciting input and recommendations to help develop guidelines for SEFs that will facilitate the most efficient market structure and achieve the objectives set forth in the law. During this process, there has been a lot of discussion dissecting the wording of the law to determine the exact requirements that will be placed on SEFs.

It is worth noting that the goal of the legislation is "to promote the trading of swaps on swap execution facilities and to promote pre-trade transparency in the swaps market." In addition, public comments from Chairman Gensler have emphasized the need for SEFs to employ a "many-to-many" execution structure and offer impartial access to participants. Clearly, transparency is going to be the key element for execution on SEFs.

Promoting pre-trade transparency is likely to be a requirement that ultimately determines which execution platforms are able to register as SEFs. This will be particularly important for less actively traded products, where pre/post-trade transparency has been either lacking or nonexistent. Some products and markets have been widely criticized for being overly opaque, a characterization that regulators will strive to diminish. Greater transparency will facilitate price discovery and enhance liquidity by giving new participants an incentive to become active in markets where they identify trading opportunities or inefficiencies that will allow them to profit from providing liquidity.

In an opaque world, this isn't likely to happen. Historically, less transparent markets, such as long tenor swaptions and non-benchmark CDS, have had correspondingly sparse volume and fleeting liquidity. In the framework expected to be implemented for SEFs, one that forces pre-trade transparency, a greater number of participants are likely to provide liquidity driving bid/ask spreads toward market clearing levels reflecting the risk involved.

We expect multiple execution venues to exist within the SEF framework, largely driven by differences in volume and liquidity among products and markets. The CFTC anticipates 40+ firms will register as SEFs. Competition among them will allow the markets to determine the most efficient execution structure for each product area. For highly liquid products, such as interest rate swaps, a central limit order book structure is the likely outcome. This would be especially true for on-the-run or benchmark swaps where there are many participants and the daily trading volume is relatively high.