Streetwise Professor

There are reports that the CFTC will vote on the SEF rule next week.  The rule had been in limbo for months due to Gensler’s insistence that the rule require those requesting a quote solicit them from five potential counterparties.  Gensler has apparently relented because he could not get the new Democratic commissioner, Mark Wetjen, to join with Chilton and Gensler to vote out the 5 RFQ rule.

The compromise will require users to solicit two quotes for the next two years, and then three thereafter.

Whatever.

On the 1 year anniversary of the DFA, I named the SEF mandate as The Worst of Frankendodd. I haven’t changed my mind on that, though the competition is fierce.  And the RFQ requirement is the Worst of the Worst.  It is defended as a way of  improving competition.

This is at best paternalistic.  It presumes that those who want to enter into swaps don’t know their own interests.  Perhaps Gensler thinks that the buy side suffers from some sort of Stockholm Syndrome after years of captivity to the dealer banks.

In reality, buy side firms-most of whom are extremely experienced and sophisticated-are making trade-offs between competition and information leakage.  They are trying to minimize cost of execution, and have the information and incentive to do that.  Note too that they are required to do this for every trade, regardless of instrument, size, and other factors that may influence the trade-off.  But nope, one size fits all. They should be allowed to make that trade-off themselves, without any guidance from Gary.

RFQ5?  How about RFQ0?

Here’s an analogy.  How would you like it if the government told you how many stores you had to visit before making a purchase?  You know, to make sure that you get the best price.  Call it the CS5 rule.  You have to comparison shop at five stores before making a purchase.  On everything.   Of course, when deciding on whether to shop at one store or five, you trade-off the potential savings (which will depend on the value of the purchase, the good you are shopping for, and other factors) from shopping around more, against the cost (which will vary with the value of your time, how hurried you are, your income, the price of gas, where you live, etc.)  But none of that matters under the CS5 rule.  Want to buy a quart of milk?  Shop at five stores.  For your own good.

Yeah.  It’s that bad.  CS2 would be bad, but not that bad.

Once the SEF rule goes into effect it will be interesting to see how the structure of the industry involves.  There will be a land rush of new SEFs.  I predict there will be a shakeout, and there may well be only a single dominant SEF for each major instrument.  The SEF rule does not, as I understand it, require a SEF to send an order to another SEF offering a better quote.  Which means that the network effects of liquidity will tend to cause trading activity to “tip” to a single SEF for products big enough to support order book trading.

But the whole SEF landscape will also be shaped by the margin rules, the Bloomberg suit over those rules, block trading rules, and on and on.  The rule is not the beginning of the end, it is barely the end of the beginning.