One Moves Forward, One Doesn’t

A busy day at the CFTC today.  One big rule moved forward, another not.

The rule that moved forward implements the Frank-n-Dodd requirement that swaps be traded on “Swap Execution Facilities” or SEFs.  The proposed rule was released on a 4-1 vote, with Commissioner Jill Sommers the lone nay.

Specifically, the rule specifies:

• platforms that provide for a centralized limit order book available to all participants and/or;
• platforms based on transparent request for quote systems that provide requests for quotes that are visible to all participants on platform, allow liquidity providers to post bids and offers and provide time priority for market participants who originated a request for quote.
• Trading platforms are allowed to offer three tiers of transactions:
• Tier 1 transactions are not block trades and exhibit material transaction volume.
• Tier 2 transactions are not block trades and do not exhibit material transaction volume.
• Tier 3 transactions are not subject to clearing and execution requirements, are block trades or are illiquid or bespoke. These swaps could be executed through various methods including voice and limited request for quote systems.

I’m with Sommers on this one. The underlying presumption of the CLOB-or-Public RFQ is that the more pre-trade transparency and anonymous trading, the better for customers, and that lack of transparency is a means of enhancing dealer/market maker market power and profit.

This is not true as a general matter.  As has been seen from time immemorial in securities markets, many customers prefer to trade away from centralized markets as this reduces their trading costs.  It is possible that this “fragmentation” harms other market users more than it helps those that choose not to patronize the centralized, transparent, anonymous market.  That is a common argument, but it is not generally true.  That argument is premised on the (usually) implicit assumption that the CLOB market is perfectly competitive with free entry–which may well not be true, and in fact has been untrue in many markets.

Moreover, for many products, derivatives end-users have had the choice between trading on centralized markets (with clearing and the associated credit arrangements) and trading in decentralized dealing markets (without clearing).  Indeed, the latter combination has grown absolutely and relative to the former.  Although it is difficult to determine the contribution of each element of the transaction and post-trade bundle to traders’ decisions on where to trade, this fact raises serious doubts about the assertion that forcing trades onto centralized platforms will be overwhelmingly beneficial to derivatives end-users.

The rule that didn’t move forward, somewhat surprisingly, was that on position limits.  CFTC Chairman Gensler had already delayed voting on the proposed rule once, and did it again today.  He said that “I think it’s just appropriate to let this one ripen a bit more.”

Uhm, Gary.  It’s pretty ripe already.  As in rotten.

The new position limit proposal is less bad than the one from January.  It no longer has the silly crowd out provision, or the equally silly limited risk management exemption.  The crowd out provision essentially forced market participants to choose between being hedgers, market makers, or speculators.  That micromanagement of firm business models in contravention of the potential for synergies across these functions was an unnecessary constraint on market participants.

On the other hand, the new rule has a very restrictive definition of bona fide hedger.

Although some of the worst elements have been stripped away, the underlying problem with spec limits generally remains.  No one has yet to provide credible evidence showing that speculation has distorted prices in recent years, or even provided a credible theory to demonstrate how this can happen (other than in corners or squeezes, which are better deterred in other ways).

Although it is not quite clear as to why the rule has not garnered majority support in the Commission, anti-speculation crusader Bart Chilton indicated that he did not support the rule as written.  This is likely due in part that he was a big fan of the crowding out provision.  In his remarks after the meeting he also indicated that the two-step approach in the proposal, which would have delayed full-blown implementation of limits until the Commission had the ability to collect data from the swaps market so it would be able to base its choice of  limits on, you know, actual data.  In other words, Chilton is playing Jacobin on this issue.  Republican commissioners have expressed reservations about proceeding without such information.

Apparently, however, Gensler threw a sop to Chilton, by instructing staff to identify position levels that would trigger a Commission review that could result in an order for large traders to reduce their positions.

Position limits have proved to be an extremely contentious issue.  SEFs are very controversial as well.  Both represent attempts by the CFTC–acting at Congressional direction–to transform the ways of executing transactions, and the quantities of transactions, that consenting adults have freely chosen.  That inevitably generates opposition.  There can be justifications for doing this.  Unfortunately, neither Congress nor the CFTC have provided even remotely plausible ones.

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