Path Forward for Centralized Execution of Swaps: Key Principles

The Group-of-20 (G-20) member countries agreed at their Pittsburgh Summit in 2009 to reform the derivatives markets by requiring (among other things) that all standardized derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate.

That agreement is now starting to be reflected in regulations for centralized (as opposed to bilateral) trading of derivatives. Rules developed by the Commodity Futures Trading Commission (CFTC) are already in force in the US, and the European Securities and Markets Authority (ESMA) is working to flesh out the details of a European regime under the revised Markets in Financial Instruments Directive (MIFID II).

ISDA believes it is critical that, as G-20 members move through the process of translating the 2009 objectives into specific rules, they adhere to a set of common principles. Such an approach is essential if the respective rule sets are to both properly reflect national concerns in rule-making systems and avoid regulatory disparity – which will lead to market fragmentation, low trading liquidity, regulatory arbitrage, duplicative compliance requirements and, ultimately, increased risk.

Analysis conducted by ISDA underscores these concerns. Under US swap execution facility (SEF) rules, which came into force on October 2, 2013, electronic venues that provide access to US persons are required to register with the CFTC. The first derivatives products were mandated to trade on these platforms from February 15, 2014 – a process known as made-available-to-trade (MAT). All US persons are now required to traded MAT instruments on registered SEFs or designated contract markets, but similar rules are not yet in place elsewhere.

A clear split in liquidity has emerged as a result. For instance, European dealers have opted to trade euro interest rate swaps with other European dealers rather than be subject to US rules. By December last year, 85% of euro IRS transactions were traded between European entities, up from 71% in September 2013, before the SEF rules came into force1.

One of ISDA’s major concerns is that this market fragmentation will continue and broaden as US and European regulators fail to reconcile their rule sets. This could prompt difficult and intractable negotiations as to which rule set should prevail2. The CFTC attempted to find a solution to the fracturing of liquidity in February 2014, issuing conditional no-action relief that allowed US entities to continue trading on European multilateral trading facilities (MTFs) that hadn’t registered as SEFs, so long as those platforms met requirements that were virtually identical to those applied in the US. This was considered too onerous by European venues, and the so-called qualifying MTF regime never gained traction.

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