Presented by

The Wholesale Markets Brokers' Association Americas

Prepared Remarks

J. Christopher Giancarlo
Conference Chairman
October 3, 2011

Introduction

Good morning.

I am Chris Giancarlo, Chairman of today’s program and a founding board member of the Wholesale Markets Brokers Association, Americas. 

On behalf of the WMBA, I want to welcome all of you to the Second Annual Swap Execution Facility Conference or, what we call, SEFCON II.

The WMBA Americas is an independent industry body representing the largest wholesale and interdealer brokers operating in the wholesale markets.  The five founding members of our group are:

Our current chairman is Shawn Bernardo from Tullett-Prebon, who will speak to you later this morning.

The WMBAA was formed to promote the quality and standards of our industry and the role played by wholesale brokers in the efficient functioning of global financial markets. We seek to address matters of public policy in ways that are thoughtful and constructive. Our views are informed by decades of experience as operators of marketplaces for professional market makers.

Today’s Conference.

As we sit here today, we are undoubtedly on the cusp of enormous changes in the multi-trillion Dollar OTC derivatives markets.

Fifteen months ago, Congress passed the Dodd Frank Act, including Title VII that mandates central counterparty clearing, data reporting and transaction execution on exchanges or – a new phrase - “swap execution facilities”.  What have become lovingly referred to as SEFs.

In the next few months, detailed SEF regulations are likely to be considered for adoption that will impact the entire process of transacting swaps in the United States, from clearing to reporting to execution.

Getting those rules right will impact not just the large banks that make markets in swaps products or hedge funds that trade them, but also the American corporations that use them to hedge their balance sheet risk to better manage their capital for growth and their ability to invest in US job creation.

Thus, our discussions today affect not just the insular world of Wall Street, but economic conditions on Main Street in America today.

WMBAA member firms are the prototype for SEFs

While I am speaking to you now, wholesale brokers, sometimes called “inter‑dealer” brokers, are facilitating the execution of hundreds of thousands of OTC trades corresponding to an average of $5 trillion in size across the range of foreign exchange, interest rate, Treasury, credit, equity and commodity asset classes in both cash and derivative instruments. Our industry is operating at the center of the global wholesale financial markets by aggregating and disseminating prices and fostering trading liquidity for financial institutions around the world.

The roots of our industry go back over a century in the world’s major financial centers. Our customers include large national and money center banks, major industrial firms, integrated energy and major oil companies, utilities and governmental and sovereign entities.

There is a misconception that a “Swap Execution Facility” is a new business concept created by the Dodd-Frank Act.

In fact, long before, during and after the financial crisis, the WMBAA member firms are executing swaps transactions accounting for over 90% of intermediated swaps transactions taking place around the globe. 

In passing the Dodd Frank Act, Congress recognized that the global swaps markets were widely served by such global intermediaries and created the “SEF” moniker to reflect their role in US markets and to bring them into the new Dodd Frank regulatory framework.

Swaps Market Liquidity requires Hybrid Execution Capability

The WMBA has been vocal in its support for the clearing and execution mandates of the Dodd Frank Act .  The WMBA is supportive of a regulatory regime for swaps that improves regulatory transparency, promotes competition and fosters market participant access to a vibrant, affordable source of swaps liquidity.  Yet, decades of experience in global financial markets has led the WMBA to express concern through dozens of public writings and Congressional and regulatory testimony that certain proposed SEC and CFTC regulations are overly proscriptive, could harm market liquidity, increase trading costs and, worse, could drive trading in some swaps products to overseas financial markets. This result would negatively impact US capital formation and the US businesses and jobs that support them.

It all comes down to liquidity.  Liquidity in swaps markets is fundamentally different than liquidity in futures and equities markets.  The difference in liquidity naturally determines the optimal mode of market transparency and trade execution.

In contrast to equities or futures markets, most OTC swaps markets feature a broader array of less-standardized 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 non-continuous liquidity. Such thin liquidity can often to be episodic, with liquidity peaks and troughs that can be seasonal, as with certain energy products, or more volatile and tied to external market and economic conditions, as with many credit, energy and interest rate products. 

Last week, the Federal Reserve Bank of New York published an analysis of CDS transactions over a three month period in 2010 .  The study confirms that trading in the credit derivatives market - to look at just one swaps category – is far less active than exchange traded financial markets such as futures or equities markets.

The New York Fed's analysis shows that the most active of single-name CDS contracts traded a little over 20 times per day, and some index CDS contracts traded over 100 times per day. However, the majority of single name CDS contracts trade less than once a day, but in very large sizes.  This is wholly different than the 10s of thousands of trades that take place each day in many exchange traded instruments.

For this reason, wholesale brokers’ swap trading methodologies are specifically tailored to the unique, episodic liquidity characteristics of particular swaps markets. WMBA member firms offer their services through a range of trading methodologies, including:

Integrated within this broad range of trading methodologies are teams of knowledgeable brokers using sophisticated electronic technology.  Our industry employs thousands of professionals here in the United States, who operate dozens of highly sophisticated, professional marketplaces. Our operations are a melding of man and machine.  It is what we call “hybrid brokerage.” Our transaction methods are built on customer choice.  We don’t dictate how our customers transact.  We offer them a range of methodologies and they chose the methods that best suit their needs and the liquidity characteristics of the instruments they are trading.

WMBAA Reaction to Proposed SEF Regulations:

In the past year, the WMBAA has carefully considered and publicly responded to the many SEF rule proposals announced by the CFTC and SEC.  The WMBAA appreciates the thoughtful approach of both Commissions and their staffs in implementing Dodd-Frank.  It is clear that the two staffs have worked hard to try generally to balance the compelling interests of fostering growth in competitive OTC markets while ensuring that regulatory oversight will be in place to monitor for risks to these vital markets.

The WMBAA supports the SEC’s interpretation of the SEF definition as it applies to trade execution through “any means of interstate commerce”, including the full range of RFQ systems, order books, auction platforms or voice brokerage trading that are used in the market today.  Such an approach is consistent with the letter and spirit of the Dodd-Frank Act and ensures flexibility in the permitted modes of execution.

On the other hand, the WMBAA is concerned with the CFTC’s proposed SEF rules, which works to restrict trading methods that are not exclusively central limit order book or RFQ for non-block, cleared swaps.  We believe the approach they have taken in the proposed rules is inconsistent with the requirement in the statute that SEFs can utilize “any means of interstate commerce.”  The CFTC’s approach is a one size fits all approach that limits market efficiency and customer choice.

Henry Ford famously told Model T buyers that they could have any color they wanted as long as it was black. Here the CFTC is interpreting the Dodd Act to say that, for many trades SEFs can use any means of interstate commerce, as long as it is limited to RFQ or Central Limit Order Book systems.

We believe this rule proposal is not supported by a plain reading or the legislative history of the Dodd Frank Act. Worse, it will constrain the very “hybrid” systems that are currently relied upon for liquidity formation in US swaps markets.

The commercial flaw with the CFTC’s approach is that it is largely the liquidity characteristics of a given swap product, not whether or not the instrument is cleared or part of a block transaction, that determines which blend of hybrid brokerage is adopted by the markets for any given swap product.  If a swap trades in a highly liquid market, then central limit order book systems may work fine.  If the market has limited liquidity, then electronic order book systems will not garner liquidity and other methods are more suitable.

For these reasons, it is the position of the WMBA that hybrid brokerage should be clearly recognized as an acceptable mode of trade execution for all swaps whether “Required” or “Permitted” under the CFTC’s proposals. In swaps markets without retail customer participation, the WMBA questions what useful protections are afforded to swap dealers, major swap participants, and eligible contract participants by regulations that would limit the methods by which they may execute their swaps transactions. 

Swaps Market Transparency can be Achieved through Hybrid Execution.

From our decades of experience as liquidity enhancers in swaps markets, we can clearly see that CFTC rule proposals that betray a hidden prejudice toward electronic-only swaps execution are ill suited to real market conditions.

The argument has been made that such limitations are necessary to further regulatory and market transparency. This is not the case.  WMBA members’ hybrid execution platforms provide market participants with the most current market information for the express purpose of price discovery and matching of buyers and sellers.  Hybrid execution systems can provide the swaps market with high degrees of regulatory and market transparency just as they do today in the bond markets.  Our firms expediently report trades and provide post-trade transparency (subject to block rules) regardless of execution methods.

Another argument is that swaps trading must be restricted to electronic-only systems in order to accommodate the CFTC’s proposed “15 second rule” to further pre-trade price transparency.  As proposed, that rule would require SEFs to impose a 15 second timing delay between the entry of two matched orders received from a dealer customer. 

The WMBA has pointed out that the impact of the proposed 15 Second Rule will be that a dealer will not know until the expiration of 15 seconds whether it will have completed both sides of a trade or whether another market participant will have taken one side in its place. Under the rule, the dealer has no way of knowing at the time of receiving the customer order whether it will ultimately serve as the customer’s principal counterparty or merely as its executing agent for a trade to a competitor. The result will be greater uncertainly for the dealer in the use of its capital, surely leading it to charge increased transaction costs to market participants.

While this 15 second delay may be intended by the CFTC staff to promote pre-trade transparency, the Dodd Frank Act expressly requires that transparency be balanced against the liquidity needs of the market. We question what substantive analysis has been done on the economic effects of the proposed 15 second rule, which could run up transaction costs in the US swaps markets frustrating American companies’ ability to hedge commercial risk and appropriately plan for the future.

Impartial Access

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.

The WMBAA strongly urges the CFTC to carefully consider the SEC’s impartial access proposal, which is well aligned with both the express statutory provisions and the broader goals of Title VII of the Dodd-Frank Act to promote a marketplace of competing swaps execution venues.

At the same time, there is also concern about the SEC’s interpretation of impartial access to include access to the SEF by other SEFs.  We believe that any such access must be for bona fide execution purposes, not to permit competing SEFS to gather competitive intelligence and pricing data.   SEFs must be able to set reasonable limits on participant access to assure their bona fide intention to transact.

There also is concern about some the SEC’s Proposed Rules would effectively require SEFs regulated by the SEC to artificially delay the delivery of transaction data to their participants in order to synchronize the delivery of such data with the dissemination of such data by an data warehouse .  As market participants know, the value of market information depends on the timeliness of such information.  Market participants need real-time information to accurately assess the current state of the market and to make informed trading decisions.  By requiring SEFs to artificially delay the reporting of transaction data to their participants, the SEC’s Proposed Rules may inadvertently negate the transparency benefits that SEFs are intended to provide.  This proposed rule is out of step with rules permitting securities exchanges to publish data to exchange members simultaneously with public reporting. This could severely restrict important trading mechanisms, like electronic “work up” systems that are widely used in swaps markets today.

Importance of Harmonization

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 two agencies. 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) is considered a swap subject to regulation by the CFTC.” 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.

Another area for harmonization is between rules for SEFs and rules for futures exchanges.  We are highly concerned about proposed margining requirements for swaps based on execution venue that assumes a one day liquidation horizon for exchanges and a five day liquidation horizon for SEFS.  Such a distinction may betray an institutional regulatory bias not supported by empirical evidence.

Similarly, in a world of competing regulatory regimes, business naturally flows to the market place that has the best regulations – not necessarily the most lenient, but certainly the ones that balance execution flexibility with participant protections. European and Asian markets are not imposing restrictions on methods of execution.  US regulations need to be in harmony with those of foreign jurisdictions to avoid driving trading liquidity away from US markets to those offering greater flexibility in modes of trade execution.

Implementation of Final Rules

The WMBAA believes that the timeline for implementation of the final rules is as important, if not more important than, the substance of the regulations. The WMBAA members 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.

The vast number of changes required to existing trading systems or platforms to register as a SEF will impose a substantial burden in the short term. Upon implementation of the Dodd-Frank Act and final rules, wholesale brokers that register as SEFs will be required to undertake activities that include, but are not limited to:

As this list indicates, these undertakings are monumental. This burden is compounded when considering that SEF customers will themselves be going through dramatic change, responding to new clearing, margin and capital requirements, new business conduct standards and changes to the means by which they are able to interact with their end customers.

The WMBAA suggests that the SEC and CFTC consider the implementation of earlier regulatory regimes with lesser burdens than the Dodd-Frank Act, such as the introductions of TRACE reporting for corporate bonds and Regulations SHO and NMS in the equity markets. The imposition of those regimes was far less drastic of a change to the markets and required participants to expend far fewer resources. Yet, the imposition of these regimes, particularly Regulation NMS, was conducted over a staged period to allow market participants sufficient time to comply.

The timing of rule implementation could significantly impact US financial markets.  As Commissioner Jill Sommers 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 US increases and create other opportunities for regulatory arbitrage.”   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.

The WMBAA has suggested that implementation be done in the following order:

Speaking of block trades 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 American companies’ ability to hedge commercial risk.

Another area of concern is whether the SEC may require uncleared security based swaps to be registered with SEC under the 33 Act (as opposed to cleared swaps).

Today’s Program

To address these thorny issues, we have put together a range of great panels today.  Starting with:

The challenges of new regulatory requirements from the point of view of senior executives in the eight largest intermediaries in global swaps markets. Moderated by Mike MacKenzie of the FT.

We are also honored to have some very thoughtful public officials with us today:

 We are delighted to have such a distinguished group of experts and policy makers.  We are certain to benefit from their insights.  The WMBA is pleased to provide this forum for the examination of US regulation of SEFs, not only in their own right, but also for their impact on US economic growth, market vibrancy and, most critically, job creation.

As we go through the day, let us occasionally ask ourselves questions such as:

In posing these questions, we should be aware that the answers are not only important to our US audience, but are also being considered by the financial industrialists of London and Geneva, the exchange providers of Singapore and the market operators of Hong Kong and Beijing.

It is an exciting program we have ahead of us and it is now time to get started.  I am pleased to welcome our first panel to take their place on the stage.

Thank you for your time and attention.