The Death of a SEF: The Coroner’s Report
  
Executive Summary

The derivatives market is going to change more dramatically than regulations require because it will otherwise cease to exist. A fresh coat of paint does not mask cracked beams and a leaking roof. Confidence in OTC contracts is being eroded by the LIBOR scandal and the uncertainty over credit event determinations. The trading losses of the JPMorgan CIO office have put the Volcker Rule back in vogue. The business model of the dealer community is imperiled. How many hits will the industry take before it waves a white flag?

These truths will remain regardless of who wins in November. Even some dealers want to get on with the change. Tell us what the rules are so we can adapt. 

In this environment, the swaps execution facility (SEF) has a problem. The best chance for the prosperity of the SEF is if the swaps market remains at the status quo. But there are multiple scenarios in which the SEF is made obsolete.  In contrast, designated contract markets (DCMs) benefit if the markets move to an exchange-like model, but at the same time a DCM can allow many of the existing swaps processes to survive but under a futures model. This is the confidence trick of Dodd-Frank.

SEFs are closer to an ATS than to an Exchange but in some ways, they have the worst of both worlds. SEFs have the same amount of regulatory burdens as an Exchange, a narrower slice of the derivatives market and will largely depend on the survival of the status quo. On the other hand, DCMs have just been handed a whole new product to trade under an existing set of regulations. In addition, many of the rules have been written to favor the DCM over the SEF. 

If the DCM is so great for swaps trading, why haven’t any DCMs started trading swaps since the passage of Dodd-Frank?  The reality is that there are neither SEFs nor DCMs that trade swaps today. Among the 29 firms that have announced their intention of being a regulated entity for trading swaps, most have said they will be a SEF, but SEF registration approvals will not occur until 2013. Start-ups have been burning cash for up to two years.

Do not be mistaken though. Not all of these features are exclusive to the DCM. SEFs are able to offer pre-trade transparency, order-driven trading protocols, open access, and pre-trade credit checks. But if a SEF were to implement all of the changes listed above, why wouldn’t it simply become a DCM?