SWAP EXECUTION FACILITIES:

CAN THEY IMPROVE THE STRUCTURE

OF
OTC DERIVATIVES MARKETS?

March 2011

ISDA®
INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.
 SWAP EXECUTION FACILITIES:
CAN THEY IMPROVE THE STRUCTURE
OF
OTC DERIVATIVES MARKETS?

Executive Summary

This paper discusses important issues associated with mandating the use of swap
execution facilities (SEFs) for executing certain OTC derivatives products. It asserts that such
mandates should be structured in a way that preserves the OTC derivatives market's strengths
while addressing its weaknesses, presents a set of desirable SEF characteristics to meet this
objective and identifies relatively modest infrastructure and transparency benefits that SEFs
might bring. The paper also analyzes the proposed rules of the CFTC and the SEC required by
the Dodd-Frank Act (DFA) and makes recommendations to improve, in particular, the CFTC
proposals in a manner consistent with a reasonable reading of DFA.

Structural changes to the OTC derivatives markets should be adopted flexibly to enable
them to adjust and remain liquid. Changes should be carefully constructed to allow end users to
retain (and possibly increase) their ability to effectively manage risk. To achieve these
objectives, SEFs, at a minimum, should:

• Provide maximum choice in trade execution to market participants;

• Promote pre- and post-trade transparency while maintaining liquidity;
• Have reasonable, tailored and product specific block trade exemptions.

In addition,

• Rules should be flexible enough to allow business models to evolve over time;
• Products required to be traded in SEFs should be limited to liquid, mature products;
• Rules should not be simply imported from other, fundamentally different markets but
should take into account the nature of the derivative products traded and the relative
sophistication of the market participants.

To provide a useful context when examining the likely impact of SEFs on the trading of
OTC derivatives, we start with an overview of the current market structure (Section I). Section II
examines the market's strengths and weaknesses from the perspective of both users and
regulators and presents several desirable characteristics of SEFs which should strengthen the
market. The OTC derivatives market is compared with that of futures in Section III and
1
fundamental differences in their structures are highlighted. We then examine the CFTC and SEC
proposed rules and critique provisions likely to have a negative impact on the market's
flexibility and liquidity (Section IV). The last section contains recommendations for improving
the proposed rules.

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 I. Current Market Structure for OTC Derivatives Products

Market Size and Trading Frequency

The OTC derivatives market has grown tremendously in terms of product range and size
since its inception 30 years ago. The market now consists of five primary asset classes: interest
rates, credit, commodities, equities and foreign exchange. However, other forms of derivatives,
such as weather, longevity and catastrophe, are also used.

Most analysts use figures produced by the Bank for International Settlements (BIS) to
describe the size of the market. As of June 30, 2010, the BIS estimated the market was $583
trillion in size as measured by the aggregate notional amounts of contracts outstanding. This
estimate, however, is somewhat misleading. Many analysts exclude foreign exchange ($63
trillion) from the total as foreign exchange forwards pre-date other products by decades. The BIS
estimate also splits in two swaps executed between dealers that are subsequently cleared by the
London Clearing House (LCH). This essentially double counts these transactions. The LCH was
clearing $229 trillion as of June 30, 2010 and so the total is overstated by $114.5 trillion.
Another adjustment is to update the Credit Default Swaps (CDS) market totals for current data
from the DTCC trade repository. If these adjustments are made, the marketplace is reduced to the
following components:

A. Interest rate products: $364 trillion

B. Credit products: $27 trillion
C. Commodity contracts: $3 trillion
D. Equity products $7 trillion
Adjusted Total $401 trillion

In all, interest rate products account for approximately 90% of the marketplace by
notional. While notionals outstanding are very large 1, the number of transactions executed in any
day is quite modest. For all interest rate products, some 5,500 trades are executed on an average
day globally in over 20 currencies. CDS new trade volumes typically run approximately 7,000
per day. Only a small group of CDS reference names are traded more than 20 times a day. Over
4,000 names have traded with each name having multiples of 40 contracts each 2.

1The notional amount is the basis on which payments in a derivative contract are calculated. Actual net
market value of future payments, using current market conditions, referred as the mark-to-market value is a
better measure of the risk embedded in the contract and, almost always, a fraction of the notional. Aggregate
mark-to-market value is about $25 trillion.
2 Volumes fluctuate significantly over time. There were 21,690 new credit derivative trades (13,951 Single
Name and 7,739 Index and Index Tranches) executed the week ending on March11, 2011. There was an
increase of 19,438 trades in TriOptima's repository during the week ended on February 25, 2011. It is
estimated that this increase represents approximately 80% of all trades in rate products completed, globally,
in the period. Information on trading volumes for credit derivatives, rate derivatives, bonds and futures can

3
Bilateral Execution / Counterparty Credit Risk

Swaps are generally traded on a bilateral basis, i.e., between two counterparties. Most
derivatives are executed between a bank dealer and its clients or between two dealers who seek
to hedge risks they have taken or as a means of taking on new risk. In all, there are 14 very large
global dealers but another 20 or so large banks are active in certain major markets. An exception
to the bank dealer market is the commodity derivatives market where non-bank dealers are quite
common. Dealers in the OTC derivatives markets act as principals, i.e., assume the market and
credit risks associated with the trade until its maturity. In the futures markets, futures
commission merchants (FCMs) act as agents for their clients.

OTC derivatives contracts are typically multi-year contracts and involve assumption of
credit risk as market rates move. For example, if a counterparty receives fixed rates in a 5%
environment for 10 years and the interest rate market moves to 3% in three years, the
counterparty will be exposed to its client or bank to make good on the now off-market (in the
money from the counterparty who receives the fixed rate payments point of view) derivative for
the remaining life of the transaction. As can be seen, this credit relationship is, potentially, as
long as the longest derivative contract between the two counterparties. To streamline and
standardize documentation, master derivative agreements have been developed, governing a
large percentage of all contracts. These agreements typically contain netting provisions, enabling
counterparties to offset in the money trades (assets) against those out of the money (liabilities),
thereby reducing exposure substantially. A majority of these master agreements also call for
collateral to be exchanged between the parties to further reduce the netted exposure. These
master agreements are negotiated with care to ensure each side is properly protected.

Clearinghouses

Certain derivatives contracts – plain vanilla interest rate contracts, many credit indices
and nearly 200 CDS single name reference entities – are eligible to be cleared by clearinghouse
members. In these transactions, the parties usually present a transaction to a clearinghouse for
clearing approval. If the clearinghouse accepts the transaction, the bilateral contract is novated
and the clearinghouse becomes the counterparty to each side of the transaction. The
clearinghouse requires both initial margin and variation margin to protect itself.

Clearinghouses can bring significant benefits. The default of Lehman Brothers in 2008
provides an important example. At that time, the London Clearing House was able to liquidate
over 60,000 trades representing over $8 trillion of notional value. Trades cleared by the two
largest clearinghouses, the London Clearing House and the InterContinentalExchange ("ICE"),

be obtained from the DTCC (http://www.dtcc.com/products/derivserv/data_table_iv.php), TriOptima

(http://www.trioptima.com/repository), FINRA
(http://cxa.marketwatch.com/finra/BondCenter/Default.aspx) and the CME (http://www.cmegroup.com)
respectively.

4
are almost entirely comprised of dealer to dealer trades. 3 Both of these have developed the means
to clear transactions for clients of clearing members but little business has been executed to date.

Users of Derivatives Markets: Institutions

Who uses OTC derivative products? Virtually all non-dealer business is executed by
large institutions - banks, investment managers, other financial firms, corporations hedging risk,
and other similarly sophisticated market participants. While there are thousands of end users of
OTC derivatives, perhaps 500 entities are active in global interest rates and a somewhat lower
number of participants are active in credit products. Wider use of clearinghouses for over-the-
counter derivative products has the potential to improve market resilience by lowering
counterparty risk and increasing transparency. 4

Pricing Derivative Products / Transparency

Nearly all users of OTC derivatives products have relationships with multiple dealers and
two or more dealers are typically put into competition for each deal. Pricing is very competitive
for standard transactions for creditworthy counterparties. This competition results in very narrow
spreads for the most liquid products: plain vanilla interest rate swaps, many interest rate option
products, credit indices and the most liquid single name CDS. Moreover, OTC derivative users
are typically very sophisticated and experienced and are fully capable of executing less
competitive transactions to their benefit. In fact, end users sometimes "choose not to broadcast
their transaction details to multiple participants" in order to have access to efficient and cost
effective hedging. 5 Recent surveys confirm that end users, by and large, are very satisfied with
the service, including pricing, they get from dealers. 6

Illustrative of these points is the blind test sponsored by ISDA in 2010 7. In the test, three
large investment managers asked groups of three dealers for firm pricing on five interest rate
swaps denominated in USD or Euro. (Each investment manager had a unique set of swaps.)
Interest rate swaps are quoted in basis points, i.e., hundredths of a percent. The average winning

3 For a variety of reasons, a client transaction may be included in the “dealer to dealer” clearing metrics. Due
to standard practices in the OTC derivative markets, clients may assign their role in a dealer-facing trade to
another dealer while unwinding an open position, or may use a dealer to intermediate a trade when
transacting with other dealers. In both instances, if a clearing solution is available, such client originated
trades end up as dealer to dealer trades in clearing.
4Central counterparties for over-the-counter derivatives, S G Cecchetti, J Gyntelberg, M Hollanders, BIS
Quarterly Review, September 2009, 45-58.
5 See the Coalition for Derivatives Users letter to the CFTC dated Mach 8, 2011.
6 ISDA End-User Survey: Interest Rate Swaps, October 2010.
7 “Interest Rate Swap Liquidity Test” - a report sponsored by ISDA and conducted by Atrevida Partners in

conjunction with market participants in November 2010.

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quote for the 15 swaps was a mere one tenth of a basis point over the middle of the market at the
time the quotes were sought.

In addition to obtaining competitive pricing on transactions, users of derivatives typically

have screens from dealers, containing bid and offer indications for standard transactions.
Vendors such as Bloomberg also provide composite pricing screens. A number of dealers
currently have the means to permit electronic execution of transactions, primarily in interest rates
swaps but also increasingly in other products. Inter-dealer brokers typically have live pricing
screens, enabling dealers to execute electronically. There are also a few electronic platforms,
such as Tradeweb, that are open to end users. 8

Operational Infrastructure and Valuation

The operations underpinning OTC derivatives require a sophisticated set of systems and
staff to cope with the deal flow. The industry has largely migrated to electronic confirmations of
transactions, thereby reducing legal and documentation uncertainty that had persisted for the first
two plus decades of the industry’s life. Most large firms employ straight through processing,
meaning once the trade is entered, everything else is done without human intervention.

Dealers and their clients need to value positions on a daily basis. Market prices, obtained
from screens, are used as inputs to valuation models which calculate prices for existing positions.
Theory behind the valuation models becomes generally accepted over time but changes do occur
as has been witnessed in the interest rate swap market in just the last few years. Dealers need
robust systems to price a large number of transactions for their books and records, risk
management and daily reports for clients. Dealers also need significant analytical resources to
ensure valuation techniques are adequate.

Summary

OTC derivatives are complex products, typically traded by professionals at large

institutions, involving unlimited variations of terms, market risk and credit risk, that can be
tailor-made to match the users' exact requirements, and requiring significant systems, analytical
and legal support. In the next section, we will discuss how OTC derivatives are performing -
what works, what goes wrong and, more importantly, what could go wrong.

8
An electronic platform originally developed to facilitate bond trading. Tradeweb is owned by Thomson
Reuters and 10 leading dealers.

6
II. Strengths and Weaknesses of the OTC Derivatives Market

Strengths

The OTC derivatives market has been remarkably successful in the 30 odd years of its
existence. This success is directly related to: a) the flexibility of the product itself; b) the
importance of the dealer-client relationship; c) market liquidity, d) legal certainty; e) credit risk
management mechanisms the industry has developed; and f) the confidentiality of contracts.

Product Flexibility

The product is completely flexible. Products can be devised to manage exactly any
specified risk - whether it be exposure to interest rates, inflation, commodities, weather,
catastrophe, equities, credit, etc. The exposures do not have to be general. They can be as
specific as the counterparties to transactions wish. Risks can be managed in scores of currencies
with hundreds of swap and option products with virtually any start or maturity date.

Dealer-Client Relationship

The dealer-client relationship is central to the derivatives marketplace. Dealers take

exposure to the risks that their clients want to hedge. Dealers also assume risk when clients put on
new positions by taking take the opposite side in the trade. These risks include not only outright
exposure to the principal product or market but also "basis" risk – mismatches of dates, rate
indices, frequency of payments, delivery venues, the list goes on and on. Managing portfolios of
risk requires large investments in risk systems, skilled personnel and infrastructure as well as
large pools of dedicated capital. This dedicated capital, from some of the world's largest financial
institutions, enables users of OTC derivatives to obtain very competitive pricing on
tremendously large transactions. These users range from sovereigns, supranationals, corporations
and investment firms to smaller companies and banks which are also able to take advantage of
competitive pricing. These market making activities on the part of derivative dealers provide
significant benefits to U.S. corporations and other end-users – benefits that are ultimately passed
on to the broader economy and U.S. consumers.

Market Liquidity

With large pools of capital dedicated to making prices, users can transfer large amounts
of risk, frequently in highly customized fashion, in a single transaction with minimal price
disturbance.

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Legal Certainty and Credit Risk Management

As shown in the previous section, the derivatives market amounts to hundreds of trillions
of dollars of notional amounts. The industry has managed legal risk and counterparty credit risk
by developing and using standardized contracts and confirmations, employing netting in over 50
countries and encouraging the use of collateral to cover market risk. Netting alone has reduced
credit risk by 85%, according to the BIS, from nearly $25 trillion to less than $4 trillion and
collateral has reduced it significantly more. The market could not possibly exist in its current
state without these risk mitigants in place.

Confidentiality of Contracts

Derivative contracts are confidential agreements between two counterparties. This

protects both the dealer that puts capital at risk as well as the client. The dealer can offset risk
without a knowing market trading against its position. The client can protect its risk management
or investment programs if they need to be executed over time as well as gain the benefit of better
pricing because of the dealer's protection.

Weaknesses

In spite of its success and of its ability to provide the most flexible tools for risk
management, the complexity and lack of transparency to regulators in the OTC derivatives
market have been blamed for increasing systemic risk and for having an operational
infrastructure that could be significantly improved. Critics of the OTC market have also cited
lack of price transparency as a weakness. 9

Complex Risks

The financial crisis revealed certain safety and soundness issues that OTC derivatives
might create in financial markets. The first such issue was the extent of complex derivative risk
in the marketplace – the AIG phenomenon. AIG was not alone, nor was this risk only taken in
derivative form. Complex mortgage risk was taken by many market participants in cash as well
as derivative form. This risk was not properly understood or managed by participants who
bought the mortgage bonds or who provided the mortgage protection. Dealers who bought
protection did not properly exercise appropriate counterparty risk management measures as the
risks were much larger than expected.

9
Policy Perspectives on OTC Derivatives Market Infrastructure, D Duffie, A Li, and T Lubke, Federal Reserve
Bank of New York Staff Reports, no. 424

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Interconnectivity - Systemic Risk

The second safety and soundness issue was the interconnectivity among dealers. Dealers
have many points of transactional contact with other dealers, including, of course, OTC
derivatives. It was not clear a priori how dealers might manage the risks of unwinding OTC
derivatives positions they had with a defaulting dealer, even if the exposures were collateralized.
Position and counterparty transparency was not available to the regulators. A related issue was
the risks dealers posed to end users. Although material, this risk is not as large in aggregate. For
example, the losses sustained by non-financial corporations in the Lehman bankruptcy that were
solely caused by OTC derivatives were relatively modest: only four have filed claims in excess
of $20 million against Lehman’s derivative subsidiaries 10.

Operational Infrastructure

A different type of safety and soundness concern with OTC derivatives has always been
present as a result of the infrastructure of the marketplace. Unlike exchanges, clearinghouses and
other organized trading venues, the OTC derivatives market is what its name implies - over the
counter. Each dealer and each user must construct its own infrastructure to manage its positions.
The infrastructure ranges from accounting and payment systems to valuation models, collateral
processes, portfolio reconciliations, etc. Regulators naturally believe one centralized family of
systems is better than dozens, if not hundreds of independent families, any one of which could
potentially create financial havoc if it failed.

Transparency

Most active users of OTC derivative products have access to dealers screens and vendor
pricing services. In some OTC derivatives markets, customers may actually have access to
pricing information comparable to the dealers as price aggregation services are available.
However, because users do not see the prices where transactions are actually being executed,
some users may be paying more than others for comparable products. To a large extent, users
have not complained. They have become comfortable operating within the marketplace,
soliciting prices from multiple dealers for virtually all their requirements. Nonetheless, additional
transparency might be beneficial if it does not come at the cost of less liquidity and, therefore,
higher prices. A related issue is ease of access to the marketplace. Should a market require
participants to have multiple trading relationships if a central market can exist that requires only
one such relationship?

Lack of transparency increases the room for market abuse and manipulation. In addition

10
See http://chapter11.epiqsystems.com/LBH/claim/SearchClaims.aspx?rc=1

9
to needing transparency to monitor risk in the marketplace, regulators require transparency to
prevent market abuse and manipulation.

Strengthening the Market - Execution Platforms

DFA addresses the significant safety and soundness issues primarily by requiring
mandatory clearing for OTC derivatives as and when clearing becomes available. This will be
required for all but non-financial end users. A similar proposal has been made to cover European
markets. Clearing will not be available for complex derivatives as these products do not have the
liquidity or standardization required for safe clearing. Complex risk will be visible through trade
repository data (also mandated by DFA and its European equivalent) and better regulatory
oversight. Trade repository data will also help regulators identify concentrations of counterparty
and market risk.

Structural changes to the OTC derivatives marketplace that do not address safety and
soundness need to be carefully constructed so as to preserve the market’s strengths while
addressing its weaknesses. When trade-offs need to be made, flexibility of approach is
recommended to enable markets to adjust and remain liquid. Regulators have recognized that
there are a number of different electronic trading models that could potentially be used for
derivatives trading. 11 What then should a SEF be? In our view a SEF should be an effective
marketplace offering derivative users broad choice in trade execution at very low cost. SEFs
should be structured in ways such that end-users retain (and possibly increase) the flexibility they
now have in executing trades and their access to the liquidity needed to effectively manage their
risk. SEFs should:

• Provide maximum choice in trade execution to market participants. Members should not
be constrained in their ability to implement their trading strategies by market rules;
• Provide pre- and post-trade transparency while maintaining liquidity.
• Have reasonable, tailored, and product specific block trade exemptions to preserve
market liquidity;
• Grant access to a broad range of qualified market participants. Access rules should be
objective and applied impartially;
• Have the ability to comply with the Core Principles 12; and
• Have direct connectivity to trade data repositories.

It is also essential that individual SEFs are not discriminated against by central clearing
organizations in terms of access and pricing.

11 See Report on Trading of OTC Derivatives by the Technical Committee of The International Organizations of
Securities Commissions (IOSCO), February 2011, for an excellent, comprehensive discussion.
12
As defined in DFA.

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III. The Markets for OTC Derivatives and for Futures Contracts
Market structures and practices evolve over time, driven by the needs of market
participants. Where there is the potential for frequent trading of a financial (or commodity) asset,
with a large number of buyers and sellers, one or more venues emerge to promote such trading
by facilitating the execution of transactions by standardizing commercial terms, developing
processes to complete transactions quickly and accurately and mitigating credit and other risks.
Some of these markets evolve into exchanges. Much of the trading in futures contracts and a
substantial portion of the trading in equities is now done on regulated exchanges. Successful
exchange-traded products rely on relatively active order submission by many buyers and sellers
creating high transaction flow.

Exchange-traded markets offer no guarantee of trading liquidity as evidenced by the high

percentage of new exchange-listed products that regularly fail to enjoy active trading. For those
contracts that do become liquid, exchanges allow a broad range of trading customers (including
retail customers) meeting margin requirements to transact a small number of highly standardized
contracts in relatively small amounts. As a result of the high number of market participants and
the relatively small number of standardized instruments traded and the credit of a central
counterparty clearer, liquidity in exchange-traded markets is relatively continuous in character.
However, average ticket size is quite small and users often need to take significant market risk to
execute large positions in smaller pieces over an extended period of time.

At the other end of the spectrum are markets such as those for OTC derivatives. Here, the
number of potential buyers and sellers is relatively small, almost all of which are institutional,
featuring a broader array of less-standardized products. Trades are typically much larger in size
and much less frequent. Liquidity levels are highly variable and depend, to a very large extent,
on a dealer making prices for clients. This, of course, is how the OTC derivatives markets started
and remain today. Participants in these markets are very limited in number, almost all of them
are institutions and they can obtain an almost endless variety of products. Trading in virtually all
products is infrequent at best but the average size of trades dwarfs the size in the exchange-
traded markets. Indeed, users often turn to the OTC markets because they cannot execute large
enough size in the exchange-traded markets in one trade.

The table in the next page summarizes the main differences between the futures markets
and the OTC derivatives markets.

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 OTC Swap Market vs Listed Futures Markets 13

Characteristic OTC Swaps Listed Futures

Trading Counterparties < 1,000 >> 100,000

Retail Participation None Significant

Daily Trades < 20,000 > 1,000,000

Tradable Instruments >> 100,000 14 < 1,000

Trade Size Very Large Small

Market Structure Bilateral (OTC) Exchange

Of course, the two structures described above are not the only ones that have emerged.
Trading in US treasuries for example, arguably one of the most liquid financial instruments in
existence currently, is conducted in a number of marketplaces with different structures. Almost
all of the trading in the so-called "on-the-run" treasuries, those most recently issued and most
liquid, is conducted in electronic trading platforms like Tradeweb and BrokerTec where
customers can access multiple large providers of liquidity. A substantial portion of trading in
older, "off-the-run" treasuries is still done through wholesale brokers. Retail investors almost
invariably trade with their brokerage. There is no requirement that any trades be made entirely on
electronic platforms.

13 See Block Trade Reporting for Over-the-Counter Derivatives Markets. ISDA/SIFMA January 18,2011.

14 Inclusive of all tenors, strikes and duration.

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IV. Swap Execution Facilities: Proposed Rules
Derivatives regulation is being addressed on a global basis. In the United States, DFA has
been enacted. It delegates authority over the interest rate and commodity derivatives markets to
the CFTC and the CDS and equity derivatives markets have been assigned to the SEC. (The
CFTC also has responsibility for derivative products related to certain indices of credit and
equity instruments). Across the Atlantic, the European Market Infrastructure Regulation
("EMIR") focuses on clearing and trade reporting while Markets in Financial Instruments
Directive (MiFID) deals with, among other things, electronic trading requirements. The
International Organization of Securities Commissions (IOSCO) has recently published a study15
which analyzes the costs and benefits associated with increasing organized platform trading of
derivatives. The study provides a comprehensive discussion of considerations that need to be
addressed in making rules regarding electronic trading.

DFA
With respect to electronic trading, DFA requires that derivatives subject to mandatory
clearing be executed on a SEF provided the derivative is made available for trading there. The
electronic platform must be either a Designated Contract Market or a Swap Execution Facility .
A SEF is "a trading system or platform in which multiple participants have the ability to execute
or trade by accepting bids and offers made by multiple participants in the facility or system,
through any means of interstate commerce".

DFA is intended to be implemented by rule-making of the CFTC and the SEC. The
agencies must, of course, start with the plain language of the statute. In this respect, it does not
appear that a single dealer platform could qualify as a SEF. While multiple parties might have
the ability to execute through such a platform, they would not have the ability to accept bids or
offers made by multiple participants. They could only deal with the dealer. Is this a reasonable
outcome? It does facilitate access to competitive bids or offers but it is hard to see why every
SEF must be created the same way. Real-time reporting (except for block trades) will provide
transparency of pricing. As long as every participant that becomes a client of a member of a
clearing house has access to a SEF that does permit multiple to multiple execution, it is hard to
see the benefits of requiring every SEF to have this condition.

CFTC

The CFTC has issued 16 very specific rules regarding electronic trading. First, with respect
to determining which products are available for trading, it delegates to the individual SEFs the

15 Op. Cit.

16"Core Principles and Other Requirements for Swap Execution Facilities" published in the Federal Register
on January 7, 2011 p 1214-1259.

13
determination of whether a derivative product was made available for trading. If one SEF has
made that determination, all SEFs would be required to treat the swap as made available for
trading as well. This poses a number of issues. It does not set out any specific criteria to
determine whether a derivative product has the liquidity to trade. The IOSCO study points to two
characteristics of products that need to be addressed in determining which products should
migrate to platform trading. The two characteristics are standardization and liquidity. It goes on
to set out elements of standardization and how to assess standardization using 10 different
factors. It further examines liquidity, looking at the numbers and types of participants, each
product's characteristics and transaction size and frequency. The CFTC does not specify such an
assessment. The CFTC should state that a contract subject to mandatory clearing does not
automatically make it available for trading and that the contract must also meet minimum
liquidity and standardization characteristics. 17 The proposed rule creates a misalignment of
interest, as SEFs will presumably be established as commercial enterprises. They will have every
incentive to declare they have made a product available for trading in order to capture market
share by steering trading onto their platform, even if the product trades very infrequently.
Furthermore, if a product trades very infrequently and every trade executed is known to the
entire market as a result of SEF execution, participants will be very cautious in taking on
positions. The result will be less liquidity and worse pricing for users as the dealer-client
relationship will have been needlessly damaged. The easiest way to eliminate this conflict of
interest and its negative implications would be for the CFTC to make the "available to trade"
determination - subject to public notice and comment.

A second proposal from the CFTC requires that SEFs either be Order Books or request
for quote (RFQ) facilities. This is an unnecessarily narrow reading of the statute. It is difficult to
see the advantage of requiring only two types of facilities to qualify as SEFs when other types of
facilities might easily accomplish the goals of DFA. The CFTC further states that a participant
utilizing a RFQ must send the request to at least five participants. This appears to be another
example where the CFTC is being more precise and restrictive than it needs to be. The DFA
states that participants must only have the ability to accept multiple bids or offers - not that they
are required to ask for them. Requiring bids or offers from five dealers may make dealers
hesitant to price the transaction aggressively as at least four other market participants will know
of their winning position. 18 There may be other swaps that represent hedges for confidential
transactions and should not be presented to five dealers. The five dealer requirement limits how

17 IOSCO, Op. cit., p22.

18The SEC is aware of this problem: "However, broadly communicating trading interest, particularly about a
large trade, may increase hedging costs, and thus costs to investors as reflected in the prices from the
dealers." See 17 CFR Parts 240, 242 and 249 [Release No. 34-63825; File No. S7-06-11] Registration and
Regulation of Security-Based Swap Execution Facilities, p17.

14
participants operate in markets when it does not serve clear purposes. The requirement is bound
to reduce liquidity.

The CFTC indicates that all contract participants have impartial access to its markets and
services. This seems to preclude a business model designed for wholesale participants only. The
IOSCO study indicates that European regulators permit platform operators to categorize clients
and to make rules appropriate for the category. This does mean that different clients may be
treated in different ways. It does not seem necessary to prescribe that the business model of each
SEF must ensure that all types of clients have equal access to it.

We also note that the proposed rule that each SEF know the full market position of every
participant so that it is able to block any execution that would break a position limit appears to
provide little value and, in this case, would be very difficult to implement.

SEC

The SEC has also proposed rules 19 that would govern OTC derivatives under its
jurisdiction. The SEC approach is principles-based and is in general far less prescriptive than that
of the CFTC. It does not specify that SEFs must either be Order Books or RFQs. It does not
indicate how many participants must be asked for quotes. It does not require "unfettered access
to any and all persons". The proposed rules require however that in SEFs "that operate both
central limit and a separate RFQ mechanism, the SEF's systems would be required to ensure that
any trade to be executed in the RFQ mechanism interacted with any existing firm interest on the
central limit order book...". In addition, the SEC does require each SEF to know the full market
position of every participant just as the CFTC does.

European Proposals

The European Commission has recently issued a consultation paper 20 outlining future
policy initiatives regarding the Market in Financial Instruments Directive (MiFID). In it, the
Commission considers, among other things, the issue of trading standardized OTC derivatives on
exchanges or electronic trading platforms where appropriate, as part of its efforts to ensure
efficient safe and sound derivatives markets. The approach is principles-based rather than
prescriptive, pointing to a more flexible market environment than the U.S: "MiFID 21 is not
prescriptive about where trades must be executed and provides flexibility and a choice for
investors about where and how they wish to execute trades".

19 Op. Cit.

20European Commission Public Consultation - Review of The Markets In Financial Instruments Directive
(MiFID) 8 December 2010

21 MiFID - Markets in Financial Instruments Directive

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 To address evolving market practices and technological developments and mitigate
harmful regulatory arbitrage, the Commission proposes to introduce the concept of an organised
trading facility with a broad definition in MiFID to suitably regulate all organized trading
occurring outside the current range of MiFID venues. This definition would capture any facility
or system operated by an investment firm or a market operator that, on an organized basis, brings
together buying and selling interests or orders relating to financial instruments. This would cover
facilities or systems whether bilateral or multilateral and whether discretionary or non-
discretionary. Broker crossing systems and interdealer broker systems bringing together third-
party interests and orders by way of voice and/or hybrid voice/electronic execution would
qualify as organized trading facilities.

Under the proposals, all trading in derivatives eligible for central clearing and sufficiently
liquid would be required to move either to regulated markets, Multilateral Trading Facilities
(MTFs) or to the newly recognized organised trading facilities. 22

22
A Multilateral Trading Facility is a system that brings together multiple parties, institutional and/or retail
that are interested in buying and selling financial instruments and enables them to do so. These systems can
be crossing networks or matching engines that are operated by an investment firm or a market operator.
Instruments may include shares, bonds and derivatives.

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 V. Recommendations
SEFs may play a positive role in the OTC derivatives market. They may strengthen the
infrastructure of the market, help prevent insider trading and other market abuse as well as
increase transparency and access to markets for smaller participants. Consistent with the
provisions of DFA and with the principles listed in Section II above we recommend that:

• Rules should be flexible enough to allow business models to evolve over time;
• Participants in SEFs should not be constrained by an excessively rigid market structure;
• Products required to be traded in SEFs should be limited to liquid, mature products;
• Rules should not be simply imported from other non-analogous markets (futures, for
example) but should take into account the nature of the derivative products traded and the
relative sophistication of the market participants;
• Rules need to balance the rights and interests of the party attempting to execute a trade
with broader transparency requirements;
• SEFs should not be burdened with the implementation and operation of complex
supervisory functions such as monitoring the size of members' positions;
• "Available to Trade" determination should be made by regulators, not by the SEFs;
• Postings to any centralized price screens should be voluntary;
• Regulators should not mandate a specific trading method (Central Limit Order Book for
example) for any product;
• SEFs should have discretion in developing their own trading structures;
• Regulators should not impose rules on the potential interaction between different
execution platforms that may be offered by a SEF;
• The requirement that an RFQ must go to no less than five market participants might not
be in the best interests of those initiating trades and should be dropped;
• The CFTC's fifteen second show rule does not bring incremental benefit to trade
execution and should be scrapped;
• Reasonable exemptions should be made for the execution of "block" trades. Rules
governing block trades should have each SEF determine whether a trade is a block trade
or not. The SEF is best placed to review the swap and the block trade requirements and
to make a determination about a block trade;
• Customers should be able to choose whether and to what extent they interact with resting
orders on the SEF;
• The CFTC, SEC, and foreign regulators should cooperate and harmonize their
approaches; and
• SEFs should be gradually phased-in given the need for the market to build the requisite
infrastructure to connect to SEFs and for SEFs to connect to clearinghouses and swap
data repositories.

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We believe the implementation of these recommendations will be very helpful in addressing
some of the weaknesses in the current market while preserving its strengths.

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