On the day of its passage, I proclaimed the Swaps Execution Facility (SEF) Mandate to be the Worst of Frankendodd. Somewhat later, I called the Made Available for Trade (MAT) process to be the Worst of the Worst. Nothing that has happened since has led me to change my mind. To the contrary.
Many considerations led me to these conclusions. Most notably, the SEF mandate, especially as implemented by the CFTC, substituted government judgment for user choice in how to execute swaps transactions. In particular, the mandate imposed a one-size-fits-all execution model on a very diverse marketplace. In the swaps market, heterogeneous participants with varying objectives want to engage in heterogeneous transactions, and over time a variety of execution methods evolved to accommodate this diversity. The mandate ran roughshod over this evolved ecosystem.
Congress, and especially the CFTC, took the futures market with centralized exchanges as its model. They liked the futures markets’ pre-trade and post-trade price transparency. (Remember Gentler and his damn apples?) They liked counterparty opacity (i.e., anonymity). They liked centralized execution and a central limit order book. They liked continuous markets.
But swaps markets evolved precisely because those features did not serve the needs of market participants. The sizes of most swap transactions, and the desire of participants to transact in such size relatively infrequently, are not handled efficiently in a continuous market. Moreover, the counterparty transparency available to the parties of bilateral trades each to evaluate the trading motives of the other, thereby limiting exposure to opportunistic informed trading: this enhances market liquidity. Limited post-trade transparency makes it cheaper for dealers who took on an exposure in a trade with a customer to hedge that risk. The inter dealer broker model also facilitates the efficient transfer of risk among dealer banks.
But those arguments were unavailing. Congress and the CFTC were deeply suspicious of the bank-dominated swaps markets. They viewed this structure as uncompetitive (despite the fact that there were more firms engaged in that market than in most major sectors of the economy), and the relationship between dealers and end users as one of greatly unequal power, with the former exploiting the latter. The protests of end users over the mandate did not move them in the slightest.
I predicted several consequences of the mandate. Fragmentation along geographical/jurisdictional lines was the most notable: I predicted that non-US entities that could avoid the strictures of Frankendodd would do so. I also predicted a decline in swaps trading activity, due to the higher costs of an ill-adapted trading system.
These things have come to pass. What’s more, it’s hard to discern any offsetting benefits whatsoever. Indeed, when compliance costs and the costs of investing in and operating SEF infrastructure are considered, the deadweight losses almost certainly run into the many billions annually.
If you want detailed chapter and verse describing just how misguided the mandate is, you now have it. Thursday CFTC Commissioner Christopher Giancarlo released a white paper that exposes the flaws in the mandate as implemented by the CFTC, and recommends reforms. It is essential reading to anyone involved in, or even interested in, the swap markets.
Commissioner Giancarlo may be talking his ex-book as an executive of IDB GFI, but in this case that means he knows what he’s talking about. He carefully demonstrates the economic purposes and advantages of pre-Dodd Frank swaps market structure and trading protocols, and shows how the CFTC’s implementation of the mandate undermined these.
The most important part of the white paper is its demonstration of the fact that the CFTC made the worst even worse than it needed to be. Whereas Congress envisioned that a variety of different execution methods and platform would meet its purposes, CFTC effectively ruled out all but two: a central limit order book (CLOB) and request for quote (RFQ). It even imposed unduly restrictive requirements for RFQ trading. As the commissioner proves, the statute didn’t require this: CFTC chose it. Actually, it would be more accurate to say that Gensler chose it. Giancarlo does not name names, for obvious reasons, but I operate under no such constraints, so there it is.
Commissioner Giancarlo also goes into great deal laying out the perverse consequences of the mandate, including in addition to the fragmentation of liquidity and the inflation of costs the creation of counterproductive tensions in relations between American and foreign regulators. Perhaps the most important part of the paper is the discussion of fragility and systemic risk. By creating a more baroque, complex, rigid, illiquid, and fragmented marketplace, the CFTC’s SEF regulations actually increase the likelihood and severity of a market disruption that could have systemic consequences. This is exactly contrary to the stated purpose of Dodd-Frank.
Seemingly no detail goes unaddressed. Take, for instance, the discussion of the provision that voids swaps that fail to clear ab initio, i.e., a swap that fails to clear for any reason-even a trivial clerical error that is readily fixed-treated as if it never existed. In addition to raising transactions costs, this provision increases risks and fragility. For instance, a dealer that uses one swap to hedge another loses the hedge if one of the swaps is rejected from clearing. If this happens during unsettled market conditions, the dealer may need to re-establish the hedge at a less favorable price. Since there are no free lunches, the costs associated with these risks will inevitably be passed on to end users.
The white paper suggests many reforms, most of which comport with my original critique. Most importantly, it recommends that the CFTC permit a much broader set of execution methods beyond CLOB and RFQ, and that the CFTC let the market evolve naturally rather than dictate market structure or products. Further, it recommends that market participants be allowed to determine by contract and consent acceptable practices relating to, inter alia, confirmations, the treatment of swaps rejected from clearing, and compression. More generally, it advocates a true principles-based approach, rather than the approach adopted by the CFTC, i.e., a highly prescriptive approach masquerading as a principled based one.
One hopes that these very sound ideas get a fair hearing, and actually result in meaningful improvements to the SEF regulations but I am skeptical. The Frankendodd SEF monster has long since escaped the confines of the castle on 21st Street. Moreover, in the poisoned and reductionist political environment in DC, Dodd Frank is treated by many (Elizabeth Warren and the editorial board of the NYT in particular) as something carved on stone tablets that Barney brought down from Mount Sinai, rather than Capitol Hill. The Warren-NYT crowd considers any change tantamount to worshipping the Golden Calf of Wall Street.
But to reform the deformed and inform the uninformed you have to start somewhere, and the Giancarlo white paper is an excellent start. One hopes that it provides the foundation for reasoned reform of the most misbegotten part of Dodd Frank. I challenge the die hard defenders of every jot and tittle of this law to meet Giancarlo’s thorough and thoughtful contribution with one of their own. But I’m not holding my breath.