Streetwise Professor

In my post on the CFTC’s action (on SEFs) and non-action (on position limits), I erred in my characterization of the SEF rule as passed by the Commission on a 4-1 vote on the 16th of this month.  The rule that had been considered but not voted on at the 9 December meeting would have imposed an essentially CLOB-like model for the execution of swaps.  The initial reporting that I saw on the rule passed on the meeting on the 16th suggested that that rule had similar provisions.  I have heard from several folks who have told me that the rule as passed was actually much less prescriptive and restrictive than the one that had been mooted earlier.  I stand corrected.*

And a good thing too.  The new rule, described here, actually gives market users a choice.

Choice.  Wow.  What a concept.

Specifically, “required transactions” (trades that must be cleared, are not block trades, and which are available for trading) must be executed on either an order book or a request for quote (RFQ) facility.  RFQ facilities must disseminate quotes to at least 5 market participants, all of whom can respond to the quote request.  Alternatively, and RFQ system can be a trading system that displays streaming firm and indicative quotes on a trading screen and operates by:

Transmitting a request for quote to no less than five market participants, based upon an indicative streaming quote, taking into account any resting bids or offers that have been communicated to the requester along with any responsive quotes.

Thus, under the rule, CLOB trading is not mandated, and it is permissible for those making markets to disseminate indicative rather than firm quotes.  The rule does not impose one-size-fits-all-futures-like trading protocols on swaps dealing.

That’s a good thing.  There are a diversity of market participants, and a diversity of execution venues can evolve under the rule to satisfy their diverse needs.  (Again, note the substantial variety of trading mechanisms in the equity market, both within countries and across countries.  Why not for derivatives too?)

This is viewed as a victory for banks.  Maybe banks will benefit, but that’s no reason to lament the result: this is not a zero sum game.  The whole idea behind competition is that it facilitates the consummation of more mutually beneficial transactions than alternative arrangements.  It is perfectly possible for both banks and customers/end users to be better off under the rule than under the more restrictive proposal that was fortunately kicked to the curb. Indeed, that’s what I expect.

That’s also why I find commentary like this mystifying:

The revised rule proposal, passed by the CFTC in a 4-to-1 vote on Dec. 16, allows banks to show negotiable prices on a request-for-quote, or RFQ, system that can be limited to a select number of trading partners. This more flexible model will limit competition among swap-execution facilities and allow volumes to grow, New York-based [Alexander] Yavorsky [of Moody’s Investor Services] said in a report today. [Emphasis added.]

Huh?  How can more flexibility–more choice–limit competition among SEFs?  And if competition is reduced (leading, presumably, to higher costs) why would volumes grow?

No.  It works the other way.  The rule as implemented lays the groundwork for competition between systems with varying attributes; it permits competition on the basis of design and features, and the evolution of systems targeted at particular classes of users.

Systems that offer less value than others won’t survive in this competitive environment.  Moreover, I expect a variety of systems–some pure CLOBs, some RFQ systems that essentially facilitate negotiation among swap buyers and sellers–to survive.  I expect several types of systems to survive because this will permit a better match between the characteristics of trading systems and the characteristics of those using them.  Given the diverse characteristics of market users, one size doesn’t fit all.  And now, thanks to this more flexible and pro-competition rule, these diverse users won’t have to make do with that one size that wouldn’t fit anybody very well.

Gary Gensler was doing his best Procrustes impersonation, desiring to force everybody into the same execution bed, regardless of their actual characteristics.  Instead, under the new rule, some will avoid the uncomfortable stretching that would have resulted under Gensler’s preferred rules; others will get to keep their legs.

I understand that the rule was the subject of extended negotiation among the commissioners.  That process definitely improved the end result.  Hopefully a similar process will occur with position limits, although there are apparently still some perverse vestiges of features like the crowding-out provision in the position limit rule that is on the table.  (Perhaps more on that later.)

*It would be very helpful if approved rules were available far more quickly on the CFTC website and in the Federal Register.  There is about a week lag, which makes it very difficult to know with certainty exactly what is in these rules.