NEW YORK - There’s no shortage of market issues surrounding the implementation of Dodd-Frank Act. Among them is operational changes expected of interdealer brokers looking to register as swap execution facilities. Brokers have raised several red flags with American regulators, but have yet to find the clarity they desire. Perhaps the biggest issue yet to be resolved pertains to permissible methods of execution for cleared, non-block transactions.
The Commodity Futures Trading Commission has proposed to direct the pricing of all cleared and non-block transactions onto a market-wide accessible screen, thus satisfying one of Dodd-Frank’s primary goals of establishing pre-trade transparency. Some brokers are saying that pre-trade transparency was not the issue that caused the crisis. It was post-trade transparency, so why are brokers being asked to put every price they’re given on a screen that can be seen by all market participants, thus significantly altering the status quo and possibly jeopardizing liquidity?
The debate being fueled by these same brokers has been an uphill battle, and it’s one that may just turn into a dead end. While they highlight and underline the phrase in Dodd-Frank that details which methods of execution market participants are allowed to utilize, “by any means of interstate commerce,” to show that they should still be able to fix, match, and work-up prices off-screen as they’ve done for years, the statute itself provides a ‘Rule of Construction’ which goes a long way in nullifying the argument. In the section pertaining to SEFs, it states: “The goal of this section is to promote the trading of swaps on swap execution facilities and to promote pre-trade price transparency in the swaps market.” Meaning? Execute any way you like, as long as your prices are transparent before the trade.
Notwithstanding the simplicity of that interpretation, the regulators are finding it difficult to satisfy market participants in putting theory into practice, least of all the aforementioned IDB’s. “[The proposed] system will not work for less liquid contracts, and will harm the liquidity of the more liquid markets,” Chris Giancarlo, e.v.p. at GFI Group told Derivatives Week. “Dealers are not going to post prices on a market-wide screen and risk the chance that the market moves against their position.”
Some end users agree that pricing will suffer, but don’t view it as the next Armageddon; “From our experience in the less liquid currency markets, it seems certain that the banks will initially show less attractive pricing than we currently get [if prices are forced on-screen],” Jeffrey Weiser, founder of ROW Asset Management in California told DW. “Who knows for sure how long that lasts, but in theory it should dissipate as more market participants enter the market.”
Others, including planned SEFs, aren’t biting. A hybrid system combining voice and electronic matching would satisfy both the broker’s desire for some off-screen relationship-dependent mode of pricing and execution as well as regulatory pre-trade price transparency requirements, said Jamie Cawley, ceo of Javelin Capital Markets. “There is a solution to this problem, and it’s name is hybrid,” added Cawley. “Brokers should have no trouble assisting dealers in putting together fair prices for both liquid and illiquid contracts if they can use voice execution systems along with the prices that will be posted on-screen, thus satisfying one of Dodd-Frank’s primary goals.”
Regardless of who is right and wrong, it seems at this point that resistance to pre-trade transparency is futile. Market participants have made the point that off-screen pricing is essential to the health of the OTC derivatives market for months now, yet the CFTC has not budged. Further, a pull back by the CFTC appears to be even more unlikely if for no reason other than the potential for a political backlash with an election year looming.
