The Commodity Futures Trading Commission on Jan. 31 hosted a day-long roundtable discussion focusing on the so-called futurization of swaps. The roundtable discussion was organized by the CFTC to gather comments from a range of market participants about the shift from over-the-counter markets to futures exchanges and the implications for several pending CFTC rulemakings. The participants included representatives of banks, brokers, exchanges, trading platforms, commercial hedgers and institutional investors.
The roundtable discussion was organized by staff as part of their efforts to finalize several rules related to the trading of swaps, including the rules governing swap execution facilities and the manner of trading on SEFs, a "made available for trading" rule that will determine which swaps must be traded on SEFs, and a rule defining how SEFs set the size thresholds for block trades. The CFTC also is considering at least two rules affecting the trading of futures. One would affect the ability of futures exchanges to set block trading thresholds, the other would affect the amount of trading that can take place off-exchange through exchange-for-swaps trades, block trades and other facilities.
Throughout the discussion it was clear that views differ on the swap-to- futures shift. Some industry participants criticized the futurization trend, saying that the migration to futures is being driven mainly by arbitrary differences in regulatory requirements that undermine the goals of Dodd-Frank. Others highlighted the benefits of the shift and argued that the differences in regulatory requirements are justified by the differences in the underlying markets.
The discussion focused on two broad sets of issues, one relating to the conversion of energy swaps to futures last fall, the other to the introduction of new swap futures contracts that mimic interest rate swaps and credit default swaps. For the former, the discussion focused primarily on execution issues, with several participants urging the CFTC to carefully consider market conditions before imposing any restrictions on block trading. For the latter, the discussion centered on differences in the regulatory treatment of cleared swaps and futures in areas such as margin requirements, block trading, and open access to clearing.
Walt Lukken, president and chief executive officer of FIA, participated in the roundtable discussion and highlighted the importance of tailoring regulations to a market's particular characteristics. "The key is to ensure that the regulations being put forward are proportional to the risks and fit the attributes of those markets," Lukken said.
Comments from Commissioners
In his opening remarks, CFTC Chairman Gary Gensler commented that the CFTC has completed about 80% of the rules necessary to implement Dodd-Frank, and said this was therefore a good time to pause and consider "where we are and where we ought to go from here." Gensler said this was also a good opportunity to assess the actions taken last fall by CME Group and IntercontinentalExchange to bring their OTC energy markets into the futures regulatory environment. He noted that these two exchanges lowered the block size threshold for these contracts to facilitate this migration, and cautioned that it is important not to undermine the price discovery function of futures markets.
This concern was echoed by CFTC Commissioner Bart Chilton, who warned against the "swapification" of futures markets. By this he was referring to the conversion of energy swaps to futures and the importation of swaps-style trading methods to the futures markets. "Let's be cautious about allowing lax oversight of these futures contracts, regardless of how they were treated before they were futurized," Chilton said.
CFTC Commissioners Mark Wetjen and Scott O'Malia asked the participants in the roundtable whether the CFTC's rules need to be adjusted in light of the futurization trend. The two commissioners asked for comment on the rules for SEFs, block trading thresholds, and certain other trading related rules. O'Malia also asked for comment on the disparity in margin treatment between swaps and futures.
Both Chilton and Gensler said they viewed the futurization trend as positive and they did not appear to be concerned about complaints about its impact on the OTC swaps market. Gensler commented that he views the swap-to-futures shift as an inevitable consequence of Dodd-Frank. "Now that the entire derivatives marketplace - both futures and swaps - has comprehensive oversight, it's the natural order of things for some realignment to take place," he said.
All of the commissioners emphasized the importance of finalizing the SEF rules and allowing these trading platforms to offer their services to the swaps markets. Gensler indicated that the SEF rules could be finalized this month. "It's critical that we complete these rules," Gensler said. "The commission is close to that, and hopefully we can do that in February." He did not comment on the status of the other rules.
Call for Level Playing Field
Many of the participants in the roundtable spoke about the negative effects of the futurization trend and especially the rules that give customers incentives to use futures instead of swaps. For example, Lee Olesky, the chief executive officer of Tradeweb urged the CFTC to adopt regulations that are "fair and consistent" when it comes to execution. Dexter Senft, a Morgan Stanley executive who spoke on behalf of the International Swaps and Derivatives Association, said that material differences in the treatment of economically equivalent products should exist for "logical and objective reasons" that are based on empirical data rather than "policy agendas."
Chris Ferreri, a managing director at ICAP who spoke on behalf of the Wholesale Markets Brokers Association, pointed to differences in the margin and block trading rules, and argued more generally that the futurization trend is undermining a core principle of Dodd-Frank - that OTC swaps require a different market structure. Ferreri stressed that Dodd-Frank is designed to promote "user choice" through competitive execution and clearing, product fungibility, and trade execution using "any means of interstate commerce."
"Congressional intent for a distinct swaps regulatory regime is thwarted when the name of a product is changed from swap to future for the sole purpose of moving it from one regulatory framework to another," Ferreri said. "Even if futurization is inevitable because of a natural migration to order books as swaps become more liquid, it still begs the question why greater liquidity must move to order books operated by single-silo non-fungible exchanges."
Will Rhode, an analyst at Tabb Group, a consulting firm, warned that futurization could "destabilize" three pillars of the Dodd-Frank reforms. First, it undermines transparency by allowing firms to bypass swap dealer registration and allowing trades to bypass pre-trade transparency requirements and post-trade reporting requirements. Second, lower margin requirements will lead to more systemic risk, and third, the "vertical" structure of clearing and licensing is contrary to the 'open choice' clearing and execution structure promoted for swaps," he said.
Support for Futurization
Representatives from several exchanges said futurization should be viewed as a natural step in the evolution of the swaps markets towards greater standardization and argued that differences in regulatory treatment are justified by differences in how the markets function.
Tom Farley, senior vice president of financial markets at IntercontinentalExchange, offered some historical context for the futurization trend, discussing ICE's move in October to convert its energy swaps to futures. He explained that this was only the latest step in a decade-long evolution of the energy swaps market and was universally welcomed by ICE's customers. He also noted that the energy products became subject to a host of futures rules after the conversion, including position limits and pre-trade transparency, and called it "beyond silly" to characterize futures as less regulated than swaps.
Bryan Durkin, chief operating officer at CME Group, challenged the idea that financial futures and swaps are so similar that the regulatory treatment should be the same. Durkin emphasized that there are very distinct differences between a futures contract and a swap contract, and vehemently rejected the suggestion that moving swaps to futures would reduce transparency. Transparency has been a central premise for the development of the futures markets over many decades, he said. Trading takes place in real time, and trading and clearing information is distributed in real time. As for the suggestion that block trades allow people in futures markets to avoid pre-trade transparency, he pointed out that block trades account for just 3% of the exchange's overall volume, and the rest are done via central limit order book.
Cliff Lewis, an executive at State Street who oversees several initiatives in the area of electronic markets, endorsed the futurization trend, saying it is a big improvement for customers in terms of efficiency and risk, and argued that the regulatory differences work to the advantage of SEFs. Those advantages include tri-party custody and greater flexibility in how trades are executed, he explained. He noted that State Street operates electronic trading platforms that handle more than $200 billion per day in foreign exchange transactions, and more than half of those trades are executed through request-for-quote negotiations.
The futurization trend was also endorsed by several end-users in the energy markets. Lael Campbell, an assistant general counsel at Exelon, a utility, said the transition from swaps to futures was extremely beneficial from a compliance perspective. Many of the compliance standards in Dodd-Frank are uncertain or ambiguous, he said, while futures regulation provides "compliance clarity at minimal cost."
This view was seconded by Paul Campbell, a consultant at Deloitte who works with many energy companies. He said the move from swaps to futures has been "incredibly efficient" for companies in compliance terms and strongly encouraged the CFTC to provide more clarity on the new regulations affecting the swaps markets.
One end-user offered a different view, however. Thomas Deas, treasurer at FMC, a chemical company, said his firm uses OTC natural gas swaps to hedge some of its costs and said his firm is concerned about the transaction costs of using futures. He outlined one example of a hedge that could be constructed with either 100 OTC transactions or 144,000 futures transactions. "We're not operating a trading room and we don't have the back room facilities to handle the more than a thousand fold increase in volume," he said.
Deloitte's Campbell also noted that the migration to futures happens to be taking effect at a time when volatility is relatively low in the energy market. At some point in the future, volatility is likely to rise, and many end-users may find themselves struggling to meet higher margin requirements. For this reason he encouraged the CFTC to allow the OTC market to continue operating as an alternative way for these firms to manage their risks.
Flexibility on Block Trading
Most participants in the roundtable agreed that the CFTC should take a flexible approach on block trading, allowing the threshold to be set based not only on size of a trade but also the amount of liquidity available in the underlying market. In many cases, the market is not liquid enough to support continuous trading in a futures-style central limit order book, according to exchange executives, brokers, institutional investors and commercial hedgers.
Don Wilson, chief executive of DRW Holdings and chairman of the FIA Principal Traders Group, urged the CFTC to develop a "nuanced" block trade rule that encourages the migration of swaps to trading platforms but still permits block trades in less liquid markets. He also suggested that the CFTC should apply its rules as guidance for the market rather than a one-size-fits-all numerical formula.
One point of disagreement was on the question of how the size thresholds are set. Several participants complained that the CFTC allows futures exchanges to set their own thresholds but is proposing to set market-wide standards for SEFs. In response, DRW's Wilson pointed out that the "vertical" structure of the futures market means that one exchange can set the size threshold for the entire market, and the ability to trade the same swap on multiple SEFs means that it is "reasonable" for the CFTC to be responsible to setting one threshold for all.
62 William Thum, an executive at Vanguard, recommended a phased approach to the implementation of block trades. For the first year all swaps should be treated as block trades, he suggested. Thereafter the CFTC should review market data and set block sizes based on the volume that can be hedged immediately, and review block sizes quarterly and change the level if needed. Thum also suggested establishing a minimum liquidity threshold below which all trades could be executed as blocks.
Rick Shilts, a CFTC official, asked the roundtable participants to comment on the fact that block sizes in the energy markets can be very small, even as small as a single contract. CME's Durkin responded that there are more than 1,000 contracts in the energy market, and in some of the "more esoteric products" the number of users is quite low. "That predicates a lower threshold," he explained.
Jerry Jeske, group chief compliance officer for Mercuria Energy Trading, said block trading thresholds should be set by SEFs rather than the CFTC. "For the CFTC to attempt to manage block thresholds we fear would be disastrous," he warned. He further cautioned that forcing swap transactions into a central order book would drive brokers out of the business. "I don't think that is good for anybody. There is not enough counterparties out there," he said. Jeske added that energy market participants have migrated from using exchange-for-swaps facilities to block trading, and commented that the CFTC should "embrace this success and declare victory."
Jim Allison, a risk manager at ConocoPhillips, noted that while much of the liquidity in the energy derivatives market is now on electronic platforms - which creates transparency - the bulk of the trades are done in block transactions because often there is little or no liquidity. "We need to recognize the role that voice brokers play," he said.
William Emmitt, an executive with PVM Oil Associates, a broker specializing in energy swaps and futures, recommended that the CFTC monitor futures and OTC trading volumes to better judge the appropriateness of block sizes. Emmitt, who was speaking on behalf of the Coalition of Energy Voice Brokers, cautioned that many of the swaps that have converted to futures contracts are illiquid and must still be transacted off-exchange through a voice broker. Block sizes must be tailored to the type of product being traded, "not the venue on which it trades," he added.
Sunil Hirani, the chief executive officer of trueEX, a designated contract market for interest rate swaps, said the same argument applies to "off-the-run" maturities in the interest rate swap market, which tend to trade much less frequently than benchmark maturities such as 10 years.
Vangard's Thum agreed. "While the breadth of the [swaps] market is huge, the depth of the market is pretty shallow."
Another issue raised by several critics of futurization was the disparity in margin requirements. The CFTC rules for futures are based on the assumption that a clearinghouse can liquidate positions within one day, while the minimum for cleared swaps is five days. This issue pertains mainly to financial rather than energy swaps; the margin requirement for cleared energy swaps is based on the same one-day liquidation period as futures.
George Harrington, head of global fixed income trading at Bloomberg, argued that there is no economic reason for this disparity. Bloomberg operates an electronic swaps platform and plans to register as a SEF. Harrington noted that there is "significantly more liquidity" in cleared financial swaps than the new swap futures listed at CME and Eris, and argued that this could increase systemic risk.
ICAP's Ferreri urged the CFTC to rewrite its margin rules, which have been finalized, so that margin is calculated based on actual trading activity and liquidity and not on whether an instrument is labeled a swap or future. "Labeling a swap product as a future should not automatically result in more favorable margin treatment when the economic characteristics are otherwise identical," he said. He added that it is "troubling" that CME and Eris are currently touting the lower margin cost for swap futures over swaps as part of their marketing.
Kim Taylor, head of CME's clearinghouse, responded by explaining why a clearinghouse would need more time to handle a default involving cleared swaps and why the amount of margin needed for cleared swaps should be higher than for futures. One reason is that swaps are less standardized than futures, with more variables in their terms, and that reduces the "concentration" of liquidity and the ability to reduce risk through netting. Another reason is that the futures markets generally have a higher number of participants, which makes it easier to transfer, liquidate or auction positions of a defaulting member. Taylor also noted that CME's clearinghouse often uses a higher standard than the CFTC's minimum requirement. The new swap futures contracts are based on a two-day liquidation period, and the S&P 500 and Eurodollar futures are both higher than one day currently.
DRW's Wilson added that cleared swaps are subject to the "legally separate but operationally commingled" treatment to limit fellow customer risk, and therefore it would be reasonable for a clearinghouse to set a higher margin requirement. With LSOC, losses from a default would impact a clearinghouse's financial resources more quickly than in the futures regime, he explained.
ICE's Farley noted that "operational complexity" also plays a role. It is easier to manage a default when an exchange and a clearinghouse are under common control than in a marketplace with multiple SEFs, he said.
Copyright © 2013 by the Futures Industry Association. Members of the Futures Industry Association are allowed to distribute this publication within their own member organizations or to other members of the Futures Industry Association so long as this copyright notice and the FIA disclaimer are not removed. As to all other instances, no part of this publication may be copied, photocopied, forwarded, redistributed, modified or duplicated in any form or by any means without the prior consent of the Futures Industry Association. Unauthorized copying of this publication is a violation of the U.S. federal copyright law. To obtain permission to reproduce any portion of this newsletter, please contact Will Acworth The content of this communication is provided for general informational purposes only. The FIA provides no warranty, representation or guarantee that the content is accurate, complete or timely. It does not constitute legal or regulatory advice and should not be relied upon for this purpose. The FIA is not affiliated with and does not endorse or sponsor any third-party goods, services, links, information or Web sites that are mentioned or that appear in this communication.