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If the CFTC and self-regulatory organizations couldn't protect MF Global and Peregrine customers' money, how will they fare policing the $300 trillion swaps market?
July 12
For advocates of financial reform, May 16 marks yet another instance of federal regulators buckling under deregulatory pressure from the banking lobby.
In this iteration of a familiar theme, the Commodity Futures Trading Commission has significantly diluted a key provision in the regulation of derivatives that is required under the Dodd-Frank Act.
The $700 trillion derivatives market played a pernicious role in creating the global financial crisis of 2008. Gargantuan derivatives bets that were essentially secret bilateral contracts battered the economy as a whole, threatening the financial positions of ordinary individuals and businesses alike. Title VII of Dodd-Frank was passed to redress deficiencies in the opaque derivatives market. Among other provisions, Title VII requires most "swaps" and "security-based swaps" to be executed on regulated trading platforms called "swap execution facilities." The CFTC and the Securities and Exchange Commission have been charged with implementing SEF regulations for swaps and security-based swaps, respectively.
When the CFTC proposed its SEF regulations in January 2011, it envisioned that brokers using SEFs would be required to transmit requests for quotes to at least five prospective counterparties (the so-called RFQ5 proposal).
The RFQ5 regime yields obvious economic advantages over the erstwhile bilateral configuration of swaps contracts. Under RFQ5, a greater number of customers can compete for orders, thereby resulting in enhanced price transparency and greater efficiencies in true price discovery. This arrangement also allows for small and mid-sized dealers to better compete with the large banks that currently dominate the market.
When dealers are required to solicit multiple quotes, they have less leeway to
The derivatives market is an oligopoly, with the top five banks controlling 90% of all such contracts. An RFQ5 requirement would create opportunities for new entrants willing to make markets in swaps at disclosed prices, which would, in turn, jeopardize the oligopolists' stranglehold on the swaps industry. It should be of no surprise, then, that the largest banks have unleashed a veritable blitz on the CFTC, holding over 80 meetings with the agency in the last three years and issuing a flurry of comment letters in opposition to RFQ5.
Opponents of RFQ5 have argued that a five-quote minimum is unrealistic given the highly illiquid nature of many swap contracts. However, those arguments lose sight of the many exemptions already incorporated into the SEF rules to account for the liquidity issue. For instance, the CFTC's proposed RFQ5 requirement would not have applied at all to large-scale "block trades," bespoke swaps, or swaps exempted from clearing and execution requirements. Also, the CFTC's RFQ5 proposal would have allowed a transaction to be consummated even if the original request to five potential counterparties yielded fewer than five responses.
Increasing the number of quote recipients benefits the market as a whole, as greater price transparency leads to reduced spreads and risk premiums associated with illiquid swaps. Dealers may have to compete with new entrants for lucrative client relationships, but a broader palette of choices can only benefit customers and the financial markets at large.
Indeed, even greater efficiencies would have resulted if the CFTC had required SEF brokers to transmit quotes to all market participants, as is the current practice in futures markets. Unfortunately, the Commission has done just the opposite. The Commissioners voted 4-1 to reduce the SEF regulation's RFQ requirement to a 2-quote minimum (RFQ2), despite early resistance from Chairman Gary Gensler, who had initially favored RFQ5 and Commissioner Bart Chilton, who had initially favored a modified version of RFQ5 tied to market liquidity.
The bulge bracket dealers have had their way, as RFQ2, the absolute minimum standard required under Dodd-Frank, is now the applicable quotation requirement for SEFs under the CFTC's jurisdiction. The SEF regime, once championed as the magic pill to cure the derivatives problem, is turning out to be less potent than hoped.
As the economy slowly recovers and the Dow hits record highs, one wonders if regulators or the banking industry have truly learned the lessons of 2008.
Akshat Tewary is an attorney practicing in New Jersey, a FINRA arbitrator and a co-founding member of
