The deadline for swap execution facility (SEF) registration approaches and industry bodies are lobbying regulators over a perceived loophole, which they say could reduce choice and lead to higher trading costs.
Real-time reporting for swaps, which in the FX world includes foreign currency options, currency swaps – also known as cross-currency basis swaps – and non-deliverable forwards, is required except when there is a valid exemption, one of which is that the trade is a block trade – a trade so large that real-time reporting would potentially prejudice the parties to the transaction.
In its final rules relating to SEFs published in May, the Commodity Futures Trading Commission (CFTC) says swap trades above a specified minimum size and ‘large notional off-facility trades’ are accorded a 15-minute real-time public reporting delay, effective from July 30.
Block sizes vary according to specific currency pairs, but a common minimum size for leading currency pairs is $6,250,000.
However, exceptions apply, and section 43.6(h)(6) of the rule states there can be no reporting delay where users of swaps aggregate orders of different accounts for purposes of satisfying the minimum block-trade size, unless the trade is made on an SEF or designated contract market (DCM), with certain conditions, one of which is that the party must be an investment adviser.
For the asset management industry, the rule contained a serious deficiency: while investment advisers trading on SEFs would be covered by the exemption to the aggregation prohibition, those trading off-facility would not.
The lack of reporting delay off-SEF would leave open the possibility of information leakage and give no time for the parties to hedge out their positions before prices moved against them.
Concerned its members would be exposed, the Securities Industry and Financial Markets Association (Sifma), representing $20 trillion of assets under management, in a letter to the CFTC in late July requested no-action relief to allow for large off-facility swaps to be included in the exemption, or alternatively to be excluded from the aggregation prohibition.
“We understand that the aggregation provision is generally meant to prohibit market participants from aggregating unrelated orders simply to obtain the benefits of block trades, including delayed public dissemination and cap-size treatment,” states Sifma.
“We also appreciate that the investment adviser exception was adopted in recognition of the fact that qualified investment advisers have fiduciary responsibilities and bona fide business reasons for aggregating orders for different accounts.
“However, we have found no guidance on why large notional off-facility swaps and block trades would warrant different treatment for purposes of the investment adviser exception.”
Much to the asset management industry’s relief, the CFTC recognized its petition and on July 30 issued a letter of no-action from the aggregation prohibition with respect to large notional off-facility swaps until October 2, the deadline for SEF registration.
However, after October 2 no-action relief only applies to large notional off-facility swaps not listed or offered for trading on a SEF or DCM.
For the asset management industry, this was the equivalent of out of the frying pan and into the fire. While the no-action provision before October 2 made sense, the effect of the requirement that post-October 2 provision swaps be traded or offered for trade on an electronic facility effectively wiped out the advantage gained before that date.
“The CFTC is effectively trying to push additional swap trading on to SEFs with their approach to block-trade size aggregation,” says Matt Nevins, managing director and associate general counsel with Sifma’s Asset Management Group. “All it takes is for one SEF to list a swap, and even if all the liquidity is off-SEF, market participants will not get the real-time reporting delay unless they trade the contract on the SEF.”
The potential impact of the ruling is enormous, because the range of swaps that SEFs might list is not limited by clearing requirements or by the CFTC’s ‘made available to trade’ (MAT) mandate for swaps should be executed on SEFs or DCMs. There is also a category of ‘permitted trades’ which might be neither mandated for clearing nor eligible for MAT, but which might still be tradable on SEFs.
“It is very possible that a swap could be listed on an SEF where there is not sufficient SEF liquidity to mandate that trade for SEF trading,” says Nevins. “So the CFTC has provided a delay from real-time reporting for trades over the block size, but then undermines the reasons for that delay in not allowing it for swaps that are traded off of SEFs.
"There is a lot of concern about this in the asset management community, and as FX platforms, for example, become registered SEFs and list instruments such as NDFs for trading, managers will come under pressure to trade on those platforms when trading in size on behalf of their clients."
Despite further discussions with the CFTC, there is little expectation among investors that policymakers will change their minds ahead of the October deadline, says Nevins.
The impact, as bid offers widen to reflect increased front-running risk, is likely to be higher costs for FX market participants.