Regulatory Change: A New World for OTC Derivatives as SEFs Swap Things Around

By Courtney Doyle McGuinn | 25 September 2013

When the G20 leaders met in Pittsburgh, US, in September 2009 almost a year to the day since the collapse of Lehman Brothers the year before - which itself is now five long years ago - political leaders agreed that in future all over-the-counter (OTC) derivatives, including swaps, should be traded effectively ‘on exchange’. This ‘new normal’ trading environment emanating from then is now coming into effect, explains FIX’s head of comms, Daniella Huggins. Other new rules include the need for a central repository, common shared legal entity identifiers (LEIs), centralised clearing and so forth; all of which is introducing new technology requirements and ways of working. This blog will focus on one of the topical changes now underway – namely, the move to swap execution facilities (SEFs) and detail FIX’s efforts to help the trading community cope.

The politicians gathered at the Pittsburgh G20 meeting perhaps did not realise at the time what a mammoth task it would be to reformulate the financial markets, end non-corporate hedging off exchange OTC trading and to introduce new structures such as swap execution facilities (SEFs – see the story here illustrating Integral, Triana, MarketAccess and Etrading SEF moves. Other moves such as the Tullet Prebon filling of a SEF application can be seen via the bobsguide news stream).

With a strong desire to achieve increased transparency, mitigate systemic risk, and protect against market abuse, regulators set about developing plans for how the G20 vision for the post-crash future OTC derivative markets should be realised.

Now four years on since Pittsburgh (and a little behind the original 2012 planned schedule), the US Dodd Frank Act is due instigate one of the biggest structural changes to impact the US derivative markets for decades. On 2 October, the new swap execution facilities (SEFs) will launch. This development will significantly alter the OTC derivative markets, overhauling the way in which these products are traded and creating a fragmented market structure. In Europe, the European Market Infrastructure Regulation (EMIR) is weaving its own regional changes to comply with the G20’s missives and it is obviously to be hoped that there will be consistency, but this blog will mainly focus on the US and global impact of SEFs.

New Regulatory Environment: SEFs
Getting to this start point in the new post-crash regulatory and business trading environment has definitely presented challenges. The road was not clearly signposted in advance, and for a long time it was incredibly difficult for financial market industry participants to determine what the US financial landscape would end up looking like, especially as the regulatory rules continued to evolve after the Pittsburgh G20. This trend presented a degree of uncertainty, as for example the platform providers knew they wanted to be active in this market, but were unsure how best to invest in new technologies, systems and connectivity to ensure they could be ready in time to meet the impending Dodd Frank deadlines. In some cases this may have led to the over specification of trading or clearing platforms, and as such unnecessary technology spend. Market participants knew they wanted to be at the party on time and wanted to take a more constructive rather than reactive approach, but the regulatory details were still in the preliminary stages, so much effort was duplicated.

This is a challenge that market participants continue to face in Europe, where many broker-dealers, traders, exchanges, electronic venues and financial market participants will be carefully watching the 2 October SEF deadline in the US. Scrutinising the how the SEFs fair once they go live in the US is something that all European players and indeed multinationals with operations in both spheres will be doing at the moment.

The expectation - and indeed hope - is that the rules pertaining to Europe’s proposed Organised Trading Facilities (OTFs), which are being introduced under the Markets in Financial Instruments Directive (MiFID) II regulatory regime, will be very similar to the SEF rules adopted in the US. The opportunity for Europe to align its rules with those of the US would enable recent learning, and in many cases investment, to be something that can be leveraged this side of the Atlantic. This opportunity to learn lessons is only enhanced by the fact that many of the proposed new SEF platforms will be owned by global players.

SEFs Are On The Way as 2nd October US Deadline Nears
With an estimated 40-50 SEFs planning to launch, the prospect of sourcing liquidity across a fragmented market place, also presented its concerns. In the absence of a crystal ball determining which of these platforms will prove highly liquid, and as such desirable, broker-dealers face the technical challenges and financial implications of potentially needing to connect to multiple different venues quickly and easily.

Lessons could be learnt from the equities markets which have for many years now operated under both an electronic and fragmented market structure, one within which many would argue competition and innovation have flourished. However, with the product attributes and life-cycles of equities and swaps differing so considerably, applying the existing rules and technology used extensively across the mature equity markets, to the new kid on the block may not be quite so straight forward.

With many of its 275+ member firms set to be impacted by developments across the OTC derivatives space, FIX Trading Community, the non-profit, industry-driven standards body for global trading, has placed a significant focus in recent years on helping firms industry-wide to effectively manage the implications of these regulatory developments on their business.

Initially fuelled by the desire of the broker-dealer community to be able to connect to the new platforms in an consistent and efficient manner, and by the knowledge that the existence of multiple proprietary protocols can prove much more costly for financial market participants than the use of a single standard, the FIX organisation recognised significant advantages in encouraging the use of standards such as the FIX protocol in navigating this new market structure.

The Role of Standards and FIX in the New Regulatory Environment
The use of FIX by trading venues is on the rise and many of the multilateral trading facilities (MTFs) that emerged following the implementation of MiFID I in Europe, back in 2007, chose to offer FIX connectivity. In doing so, these venues enabled trading partners to electronically connect to them in a standardised and cost‐effective manner, a move that minimised the financial implications of market entry and significantly reduced switching costs. The potential to achieve similar results within the fragmented OTC derivative markets is highly appealing and FIX has been working towards this aim.

In 2011 FIX Trading Community brought together both US and European representatives from the proposed trading platforms and the broker-dealers that wished to connect to them, to develop guidelines demonstrating how FIX could be used to trade swaps on the new SEFs.

However, at this point the rules relating to the US Dodd Frank regulation were still quite fluid, and it was unknown exactly which products the regulation would encompass. Therefore the FIX working group started with the highly liquid Credit Default Swaps (CDS) and Interest Rate Swaps (IRS) as they knew these would need to be traded electronically, and then planned to add further guidance once the rules became clearer. This led to the publication in March 2012, of an initial set of guidelines explaining how CDS and IRS products could be traded using FIX, in addition to enhancements to the FIX specification to ensure it could meet the identified business needs.

The FIX guidelines proved hugely popular, enabling SEFs to begin building their base infrastructure in a way they knew would encourage connectivity, a key concern where collaboration is vital. The success of these guidelines is evidenced by the fact that a lot of SEFs set to launch in the coming weeks, as the 2 October US deadline nears, are planning to do so offering FIX.

As the US Dodd Frank rules became more prescriptive, the FIX working group enhanced the standard’s functionality and the guidelines themselves. This led to the release earlier this month of updated guidelines explaining how FIX can be used to trade the wider range of products now covered by the requirements. The updated guidelines include recommendations for how FIX can be used to support different permutations of cross-asset trades used within the fixed income markets; enhancements to meet regulatory requirements, such as the drive for a common legal entity identifier (LEI); and the electronic booking of voice trades.

The Future: FIX Plans for Client Information
Recognising the huge potential that a standard such as FIX could bring to SEF connectivity, market participants have started to explore additional areas where FIX could prove beneficial. This has led to the commencement of an initiative looking at how standards could aid the communication of client entitlement information in the future.

Before being able to trade on a SEF key client information will need to be logged, such as which clients are able to trade with which partners, the types of trades they can conduct, and how they should be cleared – without a standardised or electronic approach broker-dealers face the prospect of this information being requested in a multitude of different manual formats, creating significant administrative work. The FIX guidelines in this area are currently being finalised and will be available shortly. The aim is to bring increased efficiency, speed and reliability to the process.

Conclusions
The FIX initiatives outlined above are just some examples of the work the organisation has been doing to ensure firms can adapt to the new regulatory environment and use the FIX protocol to meet the new OTC derivative rules. Other examples of our work include enhancements added earlier this year to enable firms to meet the US Commodity Futures and Trading Commission’s (CFTC) swaps data repository reporting rules - not to mention their end-of-day positions and margining regulatory reporting requirements. This is in addition to functionality previously included in FIX to support the CFTC's commodities large trader reporting legislation.

FIX Trading Community’s work will not end here, there are many further projects already underway looking at how the organisation can help address the business challenges facing the OTC derivative markets and the wider fixed income market place. With so many upcoming changes taking place impacting upon financial market participants in this space, including but not limited to, the way the European OTF rules will start to shape up in coming months, the organisation will be rather busy for some time to come! As the new post-crash regulatory and business environment envisaged at the Pittsburgh G20 meeting finally comes into practice, a busy time is only to be expected.

• For further stimulating technology discussions, viewpoints and blogs please visit our new bobsguide blogger (aka contributing editor) landing page, where you can view a selection of blogs about mobile financial services (MFS), information security and capital markets from the Mobey Forum, ISACA and the FIX Trading Community respectively. Other BG Bloggers on transactional banking and a range of other topics can be viewed here.

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