What is a 'Swap Execution Facility - SEF'

A Swap Execution Facility (SEF) is a platform that allows participants to buy and sell swaps in a regulated and transparent manner. Through a mandate in the Dodd-Frank Wall Street Reform and Consumer Protection Act, SEFs change the methods previously used to trade derivatives.

BREAKING DOWN 'Swap Execution Facility - SEF'

The Dodd-Frank Act defines a swap execution facility (SEF). "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." In short, there are now several approved platforms under the SEF umbrella which allow for multiple bids and offers.

Before Dodd-Frank, the trading of swaps was traded exclusively in over-the-counter markets with little transparency or oversight. As a result, the expected role of the swap execution facility allows for transparency and provides a complete record and audit trail of trades.

The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) regulate SEFs. Regulatory changes now require clearing, settlement, and reporting functions. Requirements are also in place in Europe, but the oversight is fragmented.

An Exchange for Swaps

A SEF is similar to a formal exchange but is a distributed group of approved trading systems. The handling of trades is similar to other exchanges. Also, the Dodd-Frank Act states if no SEF system is available for specific swaps, then the previous, over-the-counter trading method, is acceptable.

Proponents argue that a SEF is a swaps exchange, much like a stock or futures exchange, and they are correct, to a degree. Centralized clearing of swaps and other derivatives reduce counterparty risks and increases trust and integrity in the marketplace. Also, a facility that allows for multiple bids and offers provides liquidity to the swap marketplace. This liquidity enables traders to close positions ahead of contract maturity.

Becoming a SEF

Many entities may apply to become a swap execution facility. To qualify, they must meet specific thresholds as defined by the SEC, CFTC, and the Dodd-Frank Act. Applicants must register with the SEC and meet specific requirements. Requirements include the platform's ability to display all available bids and offers, send trade acknowledgments to all involved parties, maintain a record of transactions, and provide a request for quote system. Further, they must meet certain margin and capital guidelines and the ability to segregate the swap exchange. Finally, the applicant must agree to abide by the 14 SEC core principles.

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