The SEC wants to regulate an obscure product known as a swap execution service. here’s why

SEC Chairman Gary Gensler testifies before a Senate Banking, Housing, and Urban Affairs Committee hearing on September 14, 2021 in Washington, D.C.

Evelyn Hockstein-Pool/Getty Images

The Securities and Exchange Commission voted unanimously to propose a rule for the registration and regulation of securities swap execution facilities.

A swap execution facility, or SEF, is an electronic trading platform that allows participants to buy and sell swaps. A swap is a contract whereby two parties exchange the cash flows or liabilities of two different financial instruments.

Swaps are a very large part of the derivatives market and they are used to manage risk. For example, one of the biggest markets is interest rate swaps. These are contracts in which one stream of future interest payments is exchanged for another.

You can also use swaps to manage market risk.

There are literally trillions of dollars in derivatives and swaps out there. Under the Dodd-Frank Act, the Commodity Futures Trading Commission, or CFTC, regulates forward swaps, including interest rate swaps, and swap execution facilities.

Previously, it was difficult to get an idea of ​​the size of trades – or even what was being traded. This raised concerns about systemic risk, especially after the mortgage market exploded during the Great Financial Crisis.

These futures-based swap execution facilities place those futures contracts on a platform that could be monitored and regulated by the CFTC. A critical player was the head of the CFTC at the time: Gary Gensler.

Indeed, Gensler is now in charge of the SEC. The agency is trying to enact similar rules that would govern securities swaps.

There are also concerns that equity swaps pose a systemic risk.

Remember, a big part of the problem with Archegos Capital Management in 2021 involved a type of device known as a “total return swap”. In this case, there was a contract that allowed one party to make payments based on a fixed rate and another party to make payments based on the total return of an underlying asset, in this case mostly ViacomCBS stock.

Archegos obtained income generated from the assets and the company was not required to disclose the stake to regulatory authorities or other counterparties. When ViacomCBS’ stock price began to fall, Archegos (which was using leverage) received margin calls it couldn’t meet, leading to a huge fire sale of assets. .

The SEC’s proposed rules would require platforms that execute securities-based swap transactions to register with the regulatory agency to increase transparency.

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