WASHINGTON The futures regulator risks stifling liquidity in swaps market by requiring traders to ask for quotes from at least five market participants, Morgan Stanley and Deutsche Bank said in a regulatory comment period that ends on Tuesday.
To shine light on the opaque over-the-counter derivatives market, the Commodity Futures Trading Commission will require many swaps to trade on new "swap execution facilities," or SEFs, one of the most contentious parts of the Dodd-Frank financial reform law.
The CFTC has specified that "block trades" won't have to move through SEFs. But the CFTC sets the bar too high for block trades, and few will qualify for the exemption, said Dexter Senft, a managing director at Morgan Stanley.
That means many large swaps would have to be executed on a SEF, broadcast to at least five other traders, and reported immediately after trading, forcing bid-ask spreads wider to account for the market risk -- or prompting some customers to avoid the trades altogether, Senft said.
"To the extent that a customer's intention to execute a large trade is 'signaled' to more than one market participant, the price of the relevant instrument will likely move adversely to the customer," Senft said.
The Securities and Exchange Commission, which has jurisdiction over SEFs for securities-based swaps, has proposed a model that would allow customers to decide how many participants could ask for quotes.
The CFTC should adopt a similar model, and get rid of the requirement that request for quotes (RFQs) go to at least five traders, said Ernest Goodrich and Marcel Riffaud, managing directors with Deutsche Bank's legal department.
"Information protection may be more important for some market participants, while seeking the most possible sources of liquidity may be a priority for others," they said.
Too much transparency would scare liquidity from the market, said the chief executive of an inter-dealer broker of credit default and securities-based swaps that plans to register as a SEF with both regulators.
"Our experience in the credit derivative market has shown us that participants will be much more likely to initiate, and respond to, RFQs if the nature of the request and the response to the request are not broadcast to the entire market," said Nicholas Stephan of Phoenix Derivatives Group.
Deutsche Bank urged the CFTC to ditch a requirement for traders to wait 15 seconds after disclosing a customer's quote before executing against it -- a pause would give the market enough time to move against the order.
"If the commission is concerned with pre-arranged principal cross trades being executed on a SEF without the benefit of public price competition, it could require swap dealers to segregate market-making activities from desks that introduce customer interest to SEFs," Deutsche Bank said.
The CFTC had proposed making its SEF regulations effective 90 days after they are finalized, but a self-regulatory organization that will oversee some parts of SEFs' compliance with the rules said that was too soon.
The National Futures Association recommended that the CFTC make its regulations effective at least six months after the regulations are published, and no earlier than January 1, 2012, to give it enough time to prepare.
(Editing by Lisa Shumaker)