It is still probably too early to derive meaningful conclusions from the impact of Swap Execution Facilities (SEF) on trading behavior. However, European regulators and counterparties can learn from the US experience as they implement the European equivalent of SEF – Organized Trading Facilities (OTF) as part of the Markets in Financial Instruments Regulation (MiFIR).

Although central clearing provides counterparty credit risk mitigation, SEF trading – because it will not become mandatory until the ‘made available to trade’ (MAT) rules are effective – is creating uncertainty and onboarding complexity rather than immediate economic benefits.

Why the uncertainty? Potential regulatory arbitrage between the Commodities and Futures Commission (CFTC) and the Securities and Exchange Commission (SEC) is one factor. Then there’s confusion about implementing the SEF trading rules. In addition, the actual start date for mandatory SEF trading varies on the one hand between the official deadline of 18 December 2013 and the market consensus estimate of Q1 2014.

Then there’s the complexity of these new rules where pre-trade credit checking involves feeding credit limits into the SEFs systems. This can easily amount to a high 5-digit number of credit limits a day (intra-day).

Add to this the operational implementation of the direct push, ping or hub approach. This is burdensome, as is the legal and operational documentation, which buy-side participants and futures commission merchants (FCM) may struggle to complete on time.

Meanwhile in Europe there are many implications for regulators and counterparties concerning the implementation of the still-to-be-defined OTF, while dealing with the widely-cited footnote 88. The note states that all multi-lateral trading in all swaps, as defined by the CFTC, must occur on SEF.

And, since the US is months, maybe years, ahead in shaping the future derivatives trading space, there is the risk (or even fear) that US rules are being imposed on European counterparties.

To sum up, the role of US and non-US persons interacting with SEF is not clear. This is bad news for European regulators who dread a negative operational impact on foreign trading platforms in which US banks participate. Non-SEF platforms already discriminate against non-US branches of US banks by excluding non-US accounts with liquidity pools. Therefore, firms might shy away from trading in the US or on SEF, to avoid being subject to US regulatory requirements.

First lessons learned:

~ Regulatory differences (EU versus US) currently dampen the road to substituted compliance regarding pre-trade transparency rules. As a result, OTF guiding rules might be altered in the process of implementing MiFIR

~ The CFTC should grant dealers and SEF operators outside their direct regulatory reach a no-action relief period until OTF rules have been finalized

~ Avoid confusion amongst market participants: establish concise guiding rules for OTF allowing sufficient time for technical and operational implementation, and avoid regulatory arbitrage between MiFIR and linked regulations (e.g. EMIR)

References:

http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister051613b.pdf