Regulation and Compliance

Goodbye Swap Execution Facilities?; Hello Designated Contract Markets

For the dozens of US electronic trading platforms preparing to become new swap execution facilities, one research firm has a strong message: You might want to become a designated contract market instead.


The reasons, according to Tabb Group: The final rules of engagement to swim in the SEF pond haven't been finalized and becoming an SEF isn't all that advantageous. In fact, many of the rules already on the books favor DCMs. That's industry parlance for exchanges, such as CME.


In a report released on Wednesday entitled: "The Death of a SEF: The Coroner's Report", Adam Sussman, director of research at Tabb Group in New York, calls SEFs "entities with no clear meaning." He predicts that over the long run, firms which had initially envisioned becoming SEFs will either switch their strategy to become DCMs or become both SEFs and DCMs.


"The best chance for the prosperity of the SEF is in the swaps market remains at the status quo," says Sussman. "But there are multiple scenarios in which the SEF is made obsolete. In contrast, designated contract markets benefit if the swap market moves to an exchange-like model. A DCM can also allow many of the existing swaps processes to survive, but under a futures market."


Although SEFs are closer to alternative trading systems than exchanges, they face the same regulatory burdens as exchanges, a narrower slice of the derivatives market and will largely depend on the survival of the status quo. Among the 29 firms that have announced their intention to becoming a regulated entity for trading swaps, most have said they will become an SEF. However, they may have to wait until 2013 to register. In the meantime, they will likely have spent plenty of money preparing for their new role as SEFs which could go a long way towards helping them become DCMs.


So far, only trueEX, funded by private investors, has become the first newcomer strictly in the swap market to win the blessing of the Commodity Futures Trading Commission as a DCM. The platform will begin trading interest rate swaps in the first quarter of 2013, before expanding into other derivative classes.


"Two years ago becoming an SEF was a logical and appropriate decision to stay competitive, but times have changed since then. If you are going to make the effort of becoming an SEF you might as well go just a bit further to become a DCM," Sussman tells  He cites wannabe SEFs offering features, such as pre-trade transparency, order-driven trading protocols, open access and pre-trade credit checks, which are also critical to the success of DCMs.


The Dodd-Frank Wall Street Reform Act of 2010 established the term SEFs to designate new electronic trading platforms dedicated solely to swaps, leaving their nitty-gritty operating rules to the CFTC to iron out. In contrast, DCMs have existed since 1938 when the Commodity Exchange Act was passed. Dodd-Frank also allows DCMs to expand the products they trade from just futures and options to include swaps.


Regulatory ease aside, there are some clear-cut operational merits to becoming a DCM, writes Sussman in his report. For one, DCMs have a well-established set of rules allowing open access, while SEFs would be allowed to restrict their membership. "Cautious firms that are unsure about the access standards of an SEF could theoretically connect to a DCM that facilitated swaps trading today," writes Sussman.


Yet another differentiator which favors the DCM model -- certainty of execution. When executed on an exchange or DCM, a trade is guaranteed to be cleared by a clearing broker. Not so, when traded on an SEF. There is a risk the trade could be deemed invalid later on should it be rejected by a clearinghouse.


"Some SEFs are trying to tackle this with a ping and hub situation, where third-party providers establish hubs that would allow all SEFs, clearinghouses and futures commission merchants [clearing brokers] to access a single credit checking location," explains Sussman. "This has the benefit of open access, but will require support from clearinghouses to be successful."


Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through




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