A swap execution facility, or SEF, is an organization that oversees exchanges of financial securities that are generally traded over the counter, meaning that there is no centralized exchange recording them. As such, an SEF acts as a kind of exchange, making sure that these trades are held to the same standards as exchange trades. The 2010 Dodd Frank Act in the United States mandates that a swap execution facility be in place for all over the counter, or OTC, trades, which generally deal with the complex financial instruments known as derivatives. These facilities are an attempt by regulators to ensure integrity and fairness are in play when it comes to trading over the counter.
Recent financial upheavals around the world have been blamed, in part, on shady dealings between institutional traders involving the complex financial instruments known as derivatives. These derivatives are often traded over the counter, one investor or organization to another, and involve large amount of capital. Without any regulation in place, these trades have the potential to be very damaging to large portions of the economy. A swap execution facility could ideally mitigate the danger of these trades.
In the simplest sense, a swap execution facility is a kind of clearing house for trades. As a stock exchange keeps records of all stock trades, so too would an SEF do the same for derivatives, stock swaps, or any other kind of trade typically done over the counter. What this entails was loosely defined by the Dodd Frank Act, although there were some general guidelines set.
For example, s swap execution facility would demand that trades are open to multiple sources. This flies in the face of traditional OTC trading, which was often arranged between institutional investors over the phone. An SEF would remove much of this phone-based trading, replacing it with a digital market which could be accessed by all. Such a market would be impartial in terms of who has the opportunity to execute the trades.
Another key component of any swap execution facility is its transparency. By keeping an eye on large trades, the SEF could ensure that no undue pressure would be put on some aspect of the market by a particularly large trade. It would also help to keep any institutional investors for becoming over-leveraged. In short, an SEF brings over the counter trades from dark corners into the light, where they can be properly monitored and regulated.
