Christopher Giancarlo’s latest white paper on swaps market reform is still a long way from becoming a new rule book for US swap execution facilities. But it has given plenty of the right signals for the course that the market should chart in the coming years.
Sometimes a blunt instrument is needed to achieve change.
In the case of SEFs, a regulatory mandate provided the US swaps market with a push that forced market participants to pay attention to and engage with platforms that have a long-term capacity to cut the cost of swaps trades for a broad market.
But in 2018, the most striking effect of the Dodd-Frank SEF rules is how little they have shaken up swaps market structure. The industry’s incumbents remain in place, though with altered infrastructure, while most of the new entrants trying to bring innovation to trading platforms have had to retreat and re-adapt to other markets.
Even with the force of one of history’s most significant pieces of financial regulation behind it, existing market power structures have proved durable.
Meanwhile, liquidity is still fragmented between dealers, trading in order books, and for the buy-side, mainly consigned to request-for-quote (RFQ).
Even more concerning is the cross-border gap between US and European dealers’ trading lines. According to an ISDA survey cited in the white paper, the average cross-border volume of euro interest rate swaps transactions between European and US dealers as a percentage of the total market for the product has fallen from 25% to 10% since the SEF rules came into being.
In the words of Giancarlo and his co-author, Bruce Tuckman: “Fragmentation has increased firms’ operational risks as they structure themselves to avoid US rules and manage multiple liquidity pools in different jurisdictions (e.g. through different affiliates). As structural complexity has grown, operational efficiency has been reduced.”
If the marketplace for swaps becomes fully electronic, it will not be legislation that gets it over the line. The swaps market’s proponents of electronic trading believe that even without regulation, their model will win out in the long term.
They should be allowed to build their products and prove it. But regulation does not need to mandate a strict model for the structure of an SEF. The time has come for market participants to make their own way, and allow more innovation to flourish.
That need not mean paring back overall regulatory influence, but redirecting it away from restrictive legislation that hasn’t performed as intended.
There is still plenty in the SEF world that deserves officials’ attention, such as why so many new innovators failed to break into the SEF world.