The Commodity Futures Trading Commission on Jan. 31 hosted a day-long roundtable discussion on the futurization of swaps. The meeting was organized by the CFTC to gather comments from market participants about the shift from over-the-counter markets to futures exchanges and included representatives of banks, brokers, exchanges, trading platforms, commercial hedgers and institutional investors.
CFTC staff attending the meeting said the discussion will help them finalize several rules related to the trading of swaps, including the rules governing swap execution facilities and the manner of trading on SEFs, as well as 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 there are strong disagreements among market participants on the swap-to-futures shift. Some industry participants criticized the futurization trend, saying that it is being driven mainly by arbitrary differences in regulatory requirements that undermine the goals of Dodd-Frank. Others highlighted the benefits of the shift for market users and regulators, 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. For the former, the discussion focused primarily on execution issues, with several participants urging the CFTC to 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.
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 that this was therefore a good time to pause and consider “where we are and where we ought to go from here.” Gensler also said the roundtable would help the CFTC 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.
CFTC Commissioner Bart Chilton echoed this concern about the use of block trades, saying the agency needs to be on guard against what he called the “swapification” of futures markets. By this he was referring to the importation of swaps-style trading methods to the energy futures markets and in particular to the use of very low thresholds for block trades. “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 needed 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.
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.
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, a venue for trading fixed income products, 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.”
Wayne Pestone, chief regulatory officer at FXAll, a company that plans to register as a SEF for foreign exchange derivatives, also called for a “level playing field” for SEFs and futures exchanges. “We simply want the swaps markets to be permitted to compete fairly with the futures markets on appropriate playing fields. Regulatory arbitrage between markets, especially arbitrage caused by the unintended consequences of a regulator’s efforts to improve one of those markets, doesn’t create the appropriate playing field to compete.”
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 disagreed with the criticism of futurization, saying it should be viewed as a natural step in the evolution of the swaps markets towards greater standardization. They also argued that differences in regulatory treatment are justified by differences in how the markets function.
Bryan Durkin, chief operating officer at CME Group, emphasized that there are distinct differences between a futures contract and a swap contract, and vehemently rejected suggestions from some participants in the discussion that moving swaps to futures would reduce transparency. Trading on futures exchanges takes place in real time, he noted, 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 the central limit order book.
Tom Farley, senior vice president of financial markets at IntercontinentalExchange, offered some historical context for the futurization trend. He explained that ICE’s move in October to convert its energy swaps to futures was only the latest step in a decade-long evolution of the energy swaps market. 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.
Cliff Lewis, an executive at State Street who oversees several initiatives in the area of electronic markets, endorsed the futurization trend, saying it benefits customers in terms of efficiency and risk. He also argued that some of the regulatory differences work to the advantage of SEFs. For example, SEFs will have greater flexibility in how trades are executed, he explained, referring to the ability to execute trades through request-for-quote mechanisms. Lewis 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, 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 as a hedging tool 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 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 the size of a trade, but also the amount of liquidity available in the underlying market. Exchange executives, brokers, institutional investors and commercial hedgers agreed that in many cases, the market is not liquid enough to support continuous trading in a futures-style central limit order book.
Don Wilson, chief executive officer 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 in the form of 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, while the ability to trade the same swap on multiple SEFs means that it is “reasonable” for the CFTC to set one threshold for all.
Neal Brady, chief executive officer at Eris Exchange, added that the execution rules for trades below the block trade threshold are stricter on exchanges than SEFs. He pointed out that on an exchange, trades in the central order book are reported instantly to the marketplace and requests-for-quote for less liquid products are seen by everyone on the platform, rather than being disseminated to a small number of counterparties.
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 refresh the thresholds on a quarterly basis. 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. Durkin added that the current thresholds were adopted “to prevent significant disruption” for customers while the market is transitioning to futures, and encouraged the CFTC to allow this to continue until “the full extent of the swap rules are clearly defined and evident to the marketplace.”
Jerry Jeske, group chief compliance officer for Mercuria Energy Trading, the U.S. subsidiary of a Swiss commodity trading company, 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 are 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 brokerage specializing in energy swaps and futures, cautioned that many of the energy swaps that were converted to futures 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 and the amount of liquidity in that product, “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. These tend to trade much less frequently than benchmark maturities. 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 the disparity in margin treatment of products that are economically equivalent. Harrington, whose firm operates an electronic swaps platform and plans to register as a SEF, noted that there is “significantly more liquidity” in cleared financial swaps than the new interest rate swap futures listed at CME and Eris, and argued that this could increase systemic risk.
Harrington was referring to the deliverable interest rate swap futures offered by CME Group and the interest rate swap futures listed on Eris Exchange. The margins for CME’s contract are based on a two-day liquidation period. At Eris, the margins for standardized swap futures are based on a two-day period, while its flex contracts are margined with a five-day liquidation period. Margins for cleared interest rate swaps must have a liquidation period of at least five days under CFTC rules, and in practice they range between five and seven days depending on the clearinghouse.
ICAP’s Ferreri, commenting on the CME and Eris contracts, said that it is “troubling” that CME and Eris are touting the lower margin cost in their marketing materials. Ferreri urged the CFTC to rewrite its margin rules 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.
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, she said. 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.
DRW’s Wilson added that cleared swaps are subject to a different customer protection regime. To protect against what some institutional investors have called “fellow customer risk,” the CFTC requires collateral posted to meet margin requirements for cleared swaps to be held “legally separate but operationally commingled.” With LSOC, losses from a default would impact a clearinghouse’s financial resources more quickly than in the futures regime, Wilson explained. Therefore it would be reasonable for a clearinghouse to set a higher margin requirement for cleared swaps than for cleared swap futures, he argued.
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.
Walt Lukken, president and chief executive officer of FIA, 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.