Streetwise Professor

Okay.  I admit it.  I was wrong.

You’re shocked, I’m sure.

About what, you’re asking?

Well, I said that the RFQ provision of the SEF regulation was the worst of the worst of Frankendodd.  After further review, I’ve decided this is incorrect.  Instead, the “available for trade” rule is the worst of the worst.

The basic idea is that a swaps execution facility applies to the CFTC to list a swap contract as “available to trade.”  If the swap meets one (or more) of six rather vague factors, after receiving comments from other market participants, the CFTC will designate the swap as available.

That would be fine, I guess, if market participants had the choice to take advantage of this availability . . . or not.  But no choice is allowed.  (Choice, it is evident, is an anathema in Frankendodd.  DFA is all about making you eat your Brussels sprouts.)

Thus, once the CFTC designates something as available to trade on a SEF, all market participants subject to the SEF rule (i.e., pretty much everyone other than certain end users) must trade the contract on a SEF, or not trade it at all.  Thus, a SEF can effectively force all market participants to trade a particular instrument on a SEF, or eschew trading it altogether.

Great work, if you can get it.  The ability to make people use and buy your services.

This is beyond bizarre. The ultimate transactors internalize most of the costs and benefits of alternative means of executing a transaction.  But under the available to trade rule, they are not able to make the trade-off between these alternative means: once someone else lists a contract as available for trade, they must trade it on a SEF.  Note, moreover, that this someone else-the SEF operator-has an incentive to try to force business his way.  So the entity making the decision does not bear the full costs  and benefits of its action: indeed, it can profit from compelling others to do something that is against their interests.  That’s always a recipe for error.

Of course, the whole theory behind Frankendodd’s SEF mandate is that there is some sort of externality that leads transactors to choose inefficiently to trade bilaterally rather than on a transparent, order driven market. Just what that externality is is not obvious, to say the least: transparency is apparently a big part of that.  But even if you believe that theory, the SEF operator (a) is not going to internalize that externality, and (b) is not going to internalize the other  costs and benefits of forcing the ultimate transactors to use a particular mode of execution.  Thus, the incentives of the party that Frankendodd empowers to make the decision regarding how to trade are not aligned, even remotely, with the interests of the parties its decision affects.

Of course, a SEF must specify contractual terms of what it will make available to trade.  Market participants may try to avoid transacting something ill-suited for trading on a SEF by trading something similar, but with different terms.  But that can fall afoul of the anti-evasion provisions of Dodd-Frank.  Thus, the available to trade provision will result in (a) the coerced trading on SEFs of contracts unsuitable for it, (b) reduced trade (because market participants decide to trade less rather than trade in an inefficient way), (c) regulatory wrangling over whether some market participants are trying to evade the SEF mandate, or (d) all of the above.

Great.  Just great.

The economic justification for the SEF mandate is extremely shaky: that’s why I consider it the worst of DFA.  The implementation details only make it  worse.  These details presume either that (a) market participants don’t know their own interests, or (b) their interests are contrary to broader “social” interests.  (a) is risible, and (b) is highly dubious.  It is even more dubious to delegate to an agent that does not internalize these social interests the power to compel others who certainly bear many of the costs of the agent’s decisions to make choices they would not make voluntarily.

One last thing about the SEF mandate.  It will apparently determine the future leadership of the CFTC.  Gensler will not be reappointed, evidently.  (I shall pass over that in silence.  Need I say anything?) Relative newcomer Mark Wetjen had apparently been the frontrunner to replace him, but Wetjen’s opposition to Gensler’s obsession with RFQ5 has apparently killed his chances at becoming chairman.

My impression is that Wetjen is a serious and conscientious guy who arrived at his opposition to RFQ5 only after serious thought and efforts to determine whether the rule made any sense.  (Of course, since I think the idea made no sense, I believe he made the right call.)  But for some inexplicable reason, the RFQ rule became identified as a blow against banks, so opponents to it have become perceived as tools of the banks.* And that apparently sank Wetjen’s prospects for the chairmanship.

It’s a mad, mad, mad, mad world, folks.   A risible provision of the most inane aspect of Frankendodd will determine the leadership of a regulatory agency that wields incredible powers under that act.

Update: A shout out to Single Dealer Platforms (which is quite generous in linking to SWP), which expressed similar skepticism about available-to-trade before I posted this.

* The episode of my report on commodity trading firms shows pretty clearly that I don’t dance to the tune of big banks: indeed, a reporter told me that the banking group that hired me to do that report is “furious” that my report that contradicts their position has leaked out.  Yet I criticized heavily the RFQ provision.  Thus, being a bank apologist is neither necessary nor sufficient to explain opposition to the RFQ rule.