A Swap Execution Facility (SEF) is an electronic platform provided by a corporate entity that allows participants to buy and sell swaps in a regulated and transparent manner. They emerged as part of the comprehensive Wall Street reforms driven by the 2010 Dodd-Frank Act.
Key Takeaways
- Swap execution facilities (SEFs) are electronic trading platforms for swaps products.
- These platforms are mandated by the Dodd-Frank Wall Street Reform Act of 2010.
- Due to the complex nature of swaps, SEFs are not typical exchanges but function as counterparty matching services.
- Swaps traded on SEFs fall under the oversight of both the SEC and CFTC.
- The volume of swaps has increased over the years, with numerous entities now providing SEF platforms.
Understanding Swap Execution Facility
An SEF fundamentally transforms how counterparts engage in swaps transactions. Stemming from a mandate in the Dodd-Frank Wall Street Reform and Consumer Protection Act, SEFs have redefined traditional derivative trading mechanisms.
The Dodd-Frank Act describes an SEF as, “A facility, trading system, or platform in which multiple participants can 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.”
Before the Dodd-Frank Act, swaps were traded almost exclusively in over-the-counter (OTC) markets marked by low transparency and minimal oversight. SEFs provide transparency and ensure a thorough record and audit trail of trades.
Both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) regulate SEFs.
An Exchange for Swaps
While similar to traditional stock exchanges, SEFs are distributed groups of approved trading systems specifically designed for swaps. The handling of trades operationally mirrors that of other exchanges. Importantly, if no SEF is available for certain swaps, OTC trading methods remain legitimate as per the Dodd-Frank Act.
Advocates affirm that SEFs function as swaps exchanges, akin to stock or futures exchanges. Centralizing the clearing of swaps and other derivatives mitigates counterparty risks, bolstering trust and market integrity. Additionally, a facility allowing multiple bids and offers enhances market liquidity, enabling traders to close positions ahead of contract maturity.
Becoming a Swap Execution Facility
Numerous entities can apply to become a SEF, requiring adherence to specific thresholds defined by the SEC, CFTC, and the Dodd-Frank Act.
Applicants must register with the SEC and meet rigorous requirements. These include the platform’s capacity to display all available bids and offers, issue trade acknowledgments to involved parties, maintain transaction records, and provide a request for quote (RFQ) system. Moreover, they must comply with certain margin and capital guidelines and ensure the segregation of swap exchanges. Finally, adherence to the 14 SEC core principles is mandatory.
An SEF can be considered “dormant” if it hasn’t executed a swap transaction in over 12 months. A dormant SEF must re-register to activate again.
How Does a Swap Execution Facility Work?
Swap execution facilities (SEFs) operate as electronic matching platforms, bringing together buyers and sellers of swaps contracts, much like any other electronic exchange. These regulated venues typically use a request-for-quote mechanism.
Why Were Swap Execution Facilities Created?
SEFs arose under the 2010 Dodd-Frank Act, intending to better regulate and increase transparency for swaps deals, both pre- and post-trade.
Who Must Register with an SEF?
According to the CFTC, “any person who offers a trading system or platform in which more than one market participant can execute or trade swaps with more than one other market participant on the system or platform must apply to register as an SEF.”
Are Swaps Required to Be Transacted Through a Swap Execution Facility?
While many swaps must now be traded on an SEF, financial institutions can still transact certain swaps over-the-counter (OTC) directly between one another. However, swaps trades eligible for clearing must use an SEF.
Related Terms: swaps, derivatives, over-the-counter, audit trail, liquidity, exchange, request for quote
References
- FIA. “Comparison Table”.
- FIA. “Monthly Volume”.
- CFTC. “Swaps Execution Facilities (SEFs)”.
- Nasdaq. “SEFs Must Defend Against Market Abuse”.
- Lynn Riggs, Esen Onur, David Reiffen, Haoxiang Zhu. “Swap Trading after Dodd-Frank: Evidence from Index CDS”, Journal of Financial Economics Volume 137, Issue 3, September 2020, Pages 857-886.
- The Securities and Exchange Commission. “Derivatives”.
- The Securities and Exchange Commission. “SEC Proposes Rules for Security-Based Swap Execution Facilities”.
- Office of the Law Revision Counsel United States Code. “15 USC 78c-4: Security-Based Swap Execution Facilities”.
- Federal Register. “Swap Execution Facility Requirements”.
