There has been considerable hue-and-cry over reports that the CFTC’s SEF rule will require market participants to solicit only two quotes instead of five when using a Request for Quote (RFQ) in a swaps trade. This is being portrayed as a concession to the dealer banks that will permit them to perpetuate their alleged oligopoly.
I have always been harshly critical of the SEF mandate, and of regulations dictating how market participants execute transactions. Indeed, I named the SEF mandate the Worst of Frankendodd. And believe me, the competition is so intense, so hell to the victor.
There are diverse market participants trading diverse instruments, and there is no one-size-fits-all best execution mechanism: diverse execution mechanisms have evolved to accommodate diversity in products and transactors.
This is true of RFQ mandates too. Indeed, it is passing strange that anyone believes that requiring end users to get more quotes is in their benefit. If the goal of the execution mandates is to help end users by breaking the dealers’ alleged stranglehold on the market, why should you impose constraints/requirements on the end users? Why can’t they determine what the right number of quotes to solicit is? Don’t they know their own interests? Can’t they trade off the alleged benefits of soliciting more quotes-namely, greater competition to take the other side of the trade-against potential costs-such as information leakage? The regulation seems to be extremely paternalistic. Like end users are children who need to be made to eat their Brussels Sprouts, because they don’t know what’s good for them.
But, in fact, end users-including extremely sophisticated buy side firms like Blackrock and Pimco and FMC-know quite well what works for them. Indeed, ISDA and SIFMA just released the results of a poll showing that buy side firms-non-dealers, in other words-heartily oppose the 5 quote rule. Actually, “heartily oppose” is a putting it mildly. They hate it. By wide margins they think it will reduce liquidity and raise their execution costs. More than 80 percent of poll respondents expressed concerns about information leakage.
Ironically, 68 percent of the respondents said that they would try to trade instruments not subject to the SEF requirement. In other words, a regulation intended to ensure that swaps were traded on open, transparent, exchange-like platforms will instead cause traders to attempt to avoid them.
Another example of “we’re from the government and here to help you” in action.
The histrionics over the “weakening” of execution mandates also betrays the intellectual incoherence of Frankendodd and it’s advocates. The putative purpose of the law is to reduce systemic risk. Its focus on derivatives is predicated on the belief that these instruments are inherently systemically risky, and that derivatives markets are too big and need to be cut down to size.
If that’s what you believe, then you should favor of the exercise of market power by dealers. You should love-love!-a dealer oligopoly that raises the price of execution, because that reduces the size of derivative markets. You believe that derivatives markets are too big, and should be taxed: and practically speaking, a dealer oligopoly that inflates execution costs serves as a tax. It is equivalent in many ways to a transaction tax. What’s more, the rents created by such supercompetitive prices are like a boost to the capital of dealer banks which reduces the likelihood that they will need a bailout. That is, a dealer oligopoly reduces systemic risk, and increasing competition increases systemic risk.
In other words, if you believe derivatives markets are too big, you should *NOT* want to make execution more efficient. You should love love love dealer market power, and strive to do anything to enhance it, rather than reduce it. This is the theory of the second best in action.
But, sadly, intellectual coherence has never been the strong point of Frankendodd advocates. Which goes a long way to explaining what a mess it is, and what havoc it will wreak.