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The trading environment: The US story. Terry Arbit Partner (Washington, DC) Tara Mokijewski Of Counsel (London) 8 July 2015


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The trading environment: The US story

Terry Arbit | Partner (Washington, DC)

Tara Mokijewski | Of Counsel (London)

8 July 2015


What is a SEF?

Definitional Issues

• Commodity Exchange Act § 1(a)(50) defines a “swap execution facility” (“SEF”) as a

trading system or platform where multiple participants are able to execute or trade swaps by accepting bids and offers made by multiple participants

The CFTC’s implementing regulation (the “SEF rule”) focuses on platforms

that are: (1) multiple-to-multiple and (2) facilitate the execution of swaps (or

provide the ability to do so)

• Footnote 88 in SEF rule: Registration requirement applies to platforms if they facilitate the execution of any kind of swap (even swaps not required to be traded on a SEF)

• But: “Single-dealer platforms” are not required to register because they are not multiple-to-multiple

Security-based SEFs

• No SEC rules yet for SEFs for security-based swaps (i.e. equity swaps, single name/narrow-based credit default swaps)


Mandatory SEF execution

Mandatory clearing

• Certain standardized swaps must be cleared through a CFTC-registered derivatives clearing organization (“DCO”) if the CFTC determines that they should be subject to mandatory clearing

Mandatory trading

• If a swap is subject to mandatory clearing, it must be executed on a SEF or a futures exchange (called a designated contract market (“DCM”)) unless no SEF or DCM makes the swap “available to trade”

• “Made Available to Trade” (“MAT”) determinations initially made by SEF/DCM and submitted (usually through self-certification) to CFTC

• “Required Transactions” are those subject to mandatory SEF/DCM trading


Mandatory SEF execution


• Financial entities

• Commercial end-users when ineligible for “end-user exception”

because they are not hedging or mitigating commercial risk


• Swaps subject to clearing mandate that are determined to be “made available to trade”

• Unless large enough to qualify as a block trade or exempt from

clearing/trading under end-user exception


• Started February 15, 2014 for certain interest rate swaps

• Started March 3, 2014 for certain credit default swaps


SEF execution methods

Minimum functionality”: Order book

• SEFs must offer an order book for all swaps listed on the SEF

• An order book is a trading system in which all market participants have the ability to enter multiple bids and offers, observe or receive bids and offers, and transact on such bids and offers

Request for quote (“RFQ”)

• SEFs may also offer an RFQ trading system

• Through an RFQ system, a market participant may transmit a request for quote for a swap, to which other market participants may respond


SEF execution methods

Required transactions

• Must be traded using an Order Book or RFQ

• Order Book / RFQ Interaction: When an RFQ requester receives the first responsive bid or offer, the SEF must communicate to the requester any firm bid or offer pertaining to the same instrument resting on the SEF’s Order Book

• Some SEFs use voice-based systems as a form of RFQ

Permitted transactions

• May be traded by any method of execution, including voice-based systems (i.e., not limited to Order Book or RFQ)

• However, SEFs must offer an Order Book for all Permitted Transactions (even if no one uses it)




Assets All financial instruments Non-equities only All financial instruments

(but OTC only)

Swaps only Matching System Non-discretionary CLOB, RFQ, RFS Discretionary CLOB, RFQ, RFS

Full discretion (bilateral) RFQ, RFS Discretionary / Non-discretionary CLOB, RFQ, RFS Restrictions on Multilateral trading

Cannot execute against own capital and no matched principal trading

Matched principal is allowed if client is informed

Market making must be independent

Cannot operate a multilateral trading system

Permits limited matched principal trading primarily in the form of block trades



Can operate an SI and can connect to SI

Cannot operate an SI and cannot connect to another OTF

Cannot operate an OTF Limit on dealer ownership

Participants Regulated only (not for

commodity derivatives)

Can be unregulated Clients only Eligible Contract Participants

Investor Protection

Very few COB rules Full COB rules apply including best execution

Full COB rules apply including best execution

Core principles apply; SEF has discretion to examine best practices and regulations

Resilience Limited requirements

(mainly HFT focus) Limited requirements (mainly HFT focus) Limited requirements (mainly HFT focus) Detailed requirements (not mainly HFT focus)

Purpose of new rules

Requirements have been aligned with those of RMs in order to create a more level playing field

Replace broker crossing networks

Replace broker crossing networks

Replace broker crossing networks, as well as regulate secondary markets for swaps


CFTC cross-border position

• “Path forward”: CFTC staff relief that trade execution mandate can be satisfied by executing the swap on a “qualifying” MTF in EU or “qualifying” market in Australia

• “Qualifying” MTF or market need not register as a SEF with CFTC so long as it meets the access, price transparency, and other conditions equivalent to requirements imposed on SEFs in the US, for example:

1) Multilateral trading (order book for all swaps offered for trading)

2) Same execution methods (i.e., swaps subject to MAT determination must be executed on order book or RFQ-to-3)

3) Straight-through processing (including pre-trade credit checks) 4) Same block sizes as those on SEFs

5) Same swap reporting to registered swap data repositories as done by SEFs 6) Non-discriminatory access

7) Oversight equivalent to that of SEFs

• No European MTF has submitted the certification to CFTC necessary to rely upon this relief

• However, Yieldbroker Pty Limited has notified the CFTC that it intends to apply for relief as a qualifying market in Australia (by October 15, 2015)


Impact on liquidity?

• Nearly two dozen SEFs, which accounted for about half of total volume in 2014

• But: Lack of cross-border liquidity is a significant concern

• “Market fragmentation caused by the CFTC’s ill-designed trading rules – and the application of those rules abroad – is increasing the systemic risk that Dodd-Frank regulatory reform was predicated on reducing.” Commissioner Giancarlo, Financial Times, November 10, 2014


MTFs & SEFs: fragmentation of cross-border liquidity

 The CFTC’s ‘QMTF’ regime effectively became full compliance with Dodd-Frank

 CFTC’s no-action relief (intended to allow MTFs time to comply with QMTF conditions) has since expired

 Fragmented US / EU liquidity across multiple asset classes

Solution 1: an EU-based SEF-MTF (subject to dual regulation)

Solution X: another means to combine liquidity without dual regulation or cross-border issues?



1. Single liquidity pool


1. SEF must reapply for SEF licence following business transfer to UKMTF

2. Consider other US legal and regulatory implications

UK and EU Advantages

1. Single liquidity pool

2. UKMTF-SEF accesses EU participants directly

3. UKMTF-SEF can market on its own behalf across the EU

4. EU passport regimes applies


1. Dual regulation by both the FCA and CFTC

2. Consider other US legal and regulatory implications 3. Consider MTF/non-MTF functionality



US-based participants trade on the UK-based SEF/MTF


As an MTF, this entity could accept members from throughout the EU without any restrictions by using the EU passport regime. Equally, an MTF could market throughout the EU without restrictions as it is marketing its own activities and products


EU passport regime applies

Solution 1

: an EU-based SEF-MTF (subject to dual regulation)


EU entities participate directly in a UK-based



SEF lessons learned in the US

SEF issues of current interest/concern

1. Restrictive methods of execution for Required Transactions – hinders innovation 2. Reach of SEF jurisdiction to indirect participants, not just members

3. Name give-ups – does open access require anonymity?

4. Package transactions (e.g., swap spread based on LIBOR interest rate swap vs. U.S. Treasury); no-action relief for various packages from Nov. 14, 2015 until Feb. 12, 2016

5. Block trades (unclear how to do pre-trade credit checks); no-action relief-Dec. 15, 2015

6. Confirmations (uncertainty regarding whether Master Agreements can be incorporated into SEF confirmations); no-action relief to Sept. 30, 2015

7. Ongoing rulebook issues (e.g., must notify SEF of judicial or administrative proceedings against participant, even if irrelevant to SEF trading?)

8. SRO responsibilities (e.g., what surveillance duties can be performed by a third party?)

SEF rule amendments likely

• Focus is on dealer-to-dealer SEFs


Enforcement focus

Areas of recent CFTC enforcement attention:

• Manipulation: New, lower fraud-based standard under Dodd-Frank

• Anti-disruptive trading practices prohibited on a DCM or SEF under Dodd-Frank:

1. Spoofing (i.e., entering orders without intent to execute)

2. Violating bids/offers

3. Reckless disregard for orderly execution during closing period

‒ Note: SEC staff has been directed to formulate recommendations for an anti-disruptive trading rule addressing aggressive proprietary traders

• Wash sales, fictitious sales, and noncompetitive trading


Exchange disciplinary activity

Critical “rule enforcement reviews” by CFTC

• For example, Chairman Massad recently testified:

• “We have also directed self-regulatory organizations to strengthen their efforts to combat spoofing. The CFTC recently recommended, for example, that CME develop strategies to identify instances of spoofing and, as appropriate, pursue actions against perpetrators. The CFTC also recommended that CME maintain sufficient enforcement staff to promptly prosecute possible rule violations.” (May 14, 2015 Senate testimony)


• Increased exchange disciplinary activity

• Less negotiation of exchange settlements

• Anti-disruptive trade practice rules

• Focus on exchange for related position (“EFRP”) documentation


Equity market issues

Treatment of active proprietary traders

‒ Impose market-maker obligations?

‒ Require registration as broker-dealers (“BDs”)?

Algorithmic trading

‒ Require enhanced BD risk management processes?

Fairness issues

‒ Co-location; disparity in latency in data feeds; connectivity with trading venues


Other areas of SEC attention

Looking at overall regulatory structure for all types of trading venues

‒ First such systematic review since late 1990s

‒ New Market Structure Advisory Committee is part of this initiative

 Initial focus: Rule 611 of Regulation NMS (“trade-through rule”)

 Goal of Rule: Promote best execution and reduce extent to which market and limit orders can be executed away form best price

 Concerns: Increased fragmentation, market complexity, costs, and dark trading

Effect of market structure on small public companies

‒ Small cap stocks not sharing in positive market developments (reduced costs, volatility, spreads)

Dark pools

Broker conflicts, including “maker-taker” fee structures

Cybersecurity – examinations of BDs and investment advisers


Prospects for action by SEC or CFTC?

Not promising over next 2 years

‒ Both agencies on a very slow pace


‒ Chair with background in enforcement, not policy

‒ Ideologically divided Commission


‒ Consumed with international issues (e.g., equivalence with EU)

‒ Chairman has described role as “fine-tuning” what has already been done

Next Presidential election

‒ Date: November 2016


Stay up-to-date

NRF’s “Financial services: Regulation tomorrow” blog



Terry Arbit, Partner

Norton Rose Fulbright US LLP 799 9th Street, NW

Washington, D.C. 20001-4643 Tel +1 202 662 0223

Fax +1 202 662 4643


D. Grant Vingoe, Partner

Norton Rose Fulbright US LLP 666 Fifth Avenue

New York, NY 10103-3198 Tel +1 212 318 3037 Fax +1 212 318 3400


Tara Mokijewski, Of Counsel

Norton Rose Fulbright LLP 3 More London Riverside,

London, SE1 2AQ, United Kingdom Tel +44 20 7444 2134

Fax +44 20 7283 6500




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