Dodd-Frank Act and SDPs

I have been following the new legislation in the US with great interest. It seems clear that Europe intends to follow some of the rationale behind the Dodd-Frank Act (summary here). And I’m sure that regulators in Asia/Asia-Pac are following these developments closely.

I had thought the thrust of Dodds was to establish some form of central clearing facility for CDS. This would (theoretically) remove the counterparty risk which, when concentrated, can lead to scenarios like the recent crisis. This does not equate to an execution facility, so CDS deals would still be done with the bank, but the clearing facility would ensure that the counterparty risk is mitigated through margin calls on each party. Of course, the concentration risk is not mitigated but the idea is that the periodic margin calls will remove (some/most) market risk.

When we see the act itself (full text here), it mandates that cleared swaps trade via either an exchange or a Swap Execution Facility (SEF). A SEF is:

SWAP EXECUTION FACILITY.—The term ‘swap execution facility’ means a facility trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that—

(A) facilitates the execution of swaps between persons; and

(B) is not a designated contract market.

So the big question from a bank’s perspective is “is my Single Dealer Platform (SDP) an SEF”? I’m sure that the banks will have their lawyers creating arguments that support the notion that their SDP is “open to multiple participants”. Whether the CFTC believes that argument is still an open issue. If this argument is rejected, then CDS trading may disappear from the single-bank platforms completely.

So how can the banks continue to deliver CDS trading to their clients via their own portal? The act does not (yet) include non-vanilla swaps, even though these are mainly traded over voice at the moment. For vanilla swaps, e.g., iTraxx, CDX, liquid single-names, a bank may be able to deliver a form of Transaction Cost Analysis (TCA) so that a client can see the SEF composite rate alongside the bank rate, thus proving best execution. Given that the indexes trade at a fairly tight spread already, this shouldn’t prove overly burdensome.

In addition, while the aim of Dodd-Frank is to move towards a well-ordered, regulated market for CDS, the question is whether this is the first step towards moving execution away from OTC & towards an exchange-type structure for other derivative products.

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