In a speech this past Friday, CFTC Commissioner Scott O’Malia once again voiced his concern that burdensome swap dealer registration rules and disadvantageous margin requirements for swaps may be driving the futurization of derivatives trading. He proposed that the Commission host a hearing on the futurization question in order to inform development of the right rules for the swaps market.
In order for a hearing to be informative, it is essential to put the right questions on the agenda. I suggest the Commission squarely ask what swap markets are for?
We already have futures markets which, as Commissioner O’Malia acknowledges, “offer far greater regulatory certainty, deeply liquid markets within which to hedge commercial risk, and capital efficiency to market participants.” Nevertheless, we have embarked on the task of setting up a parallel regulatory framework for swaps. It makes no sense to develop this parallel framework unless the swaps marketplace is meant to host a different set of transactions than the futures market. The right rules for a swaps market will be determined by whatever defines that different set of transactions. So, a hearing should focus on the question, what is special about the derivative trades that need a swap marketplace?
The old OTC swaps market hosted many transactions that were indistinguishable from the transactions on futures markets. In fact this was the vast majority of transactions on the old OTC swaps market. Society loses nothing when those transactions migrate to futures markets. There is an incumbent industry that has a stake in preserving its old territory, but that private interest should not be a guide to CFTC rulemaking.
What the old OTC swaps market hosted that cannot be hosted on futures markets are innovative and customized derivative transactions. This is a small subset of the old OTC swaps market, but it is the subset that should be the focus of attention in CFTC rulemaking. What is special about these innovative and customized designs? How should the rules be tailored to facilitate trading in these designs? When should trade in one of these designs migrate to the futures markets, and how do the rules for the two marketplaces work together to facilitate that migration?
Commissioner O’Malia suggests that the swap rules need to be written to create a fair playing field where swaps markets and futures markets can compete for business. I cannot see the sense in that. We should not be setting up a system of regulatory arbitrage.
More importantly, the rules for swap markets cannot serve two goals at the same time. They cannot be tailored to serve both standardized derivative trading and customized derivative trading. So far, Commissioner O’Malia’s concern has been about the swaps industry losing market share in those standardized derivatives which, like the ICE cleared energy swaps, were easily moved over to the futures market. Let’s focus instead on preserving the swaps market for what it uniquely contributes to the system.
Commissioner O’Malia’s agenda for a futurization hearing should seriously explore which swap contracts are truly innovative or custom designed and therefore ill suited to the futures markets. The incumbent swaps industry likes to wave the banner of custom tailored hedging, but that banner is does not accurately represent most of their contracts. A little light shone on this question will help orient swap rulemaking in a truly useful way going forward.