The Capital Markets subcommittee of the House Financial Services Committee held a hearing yesterday on the derivatives portion of the Dodd-Frank Act — Title VII. The question of the futurization of swaps captured a good bit of attention.
Representative Bachus, who chairs the full Committee, said (at 14:04 in the video),
If all derivatives were supposed to be traded on an exchange, then they would all be futures. [Swaps] are differeent from exchange listed products, and imposing the listed futures or equity market model on [swaps] is not the mandate of Title VII.
Representative Neugebauer asked CFTC Chairman Gensler (at 1:36:27 in the video),
…others have said that [the CFTC is] overreaching the original intent of Dodd-Frank. The concern was that it was going to cause uncertainty in the market participants. And I think what we’re beginning to do now is see that play out. For example, as you’re aware, recently ICE decided to move trillions of dollars of energy swap contracts over to the futures side. And, so the question is, when you look at a lot of the rregulation and policies that you are making, it almost appears that you believe the intent of Congress was to somehow drive people out of swap market.
The Vice Chairman of the Committee, Representative Schweikert and Representative Moore put the question to me. Here is a short version of my answers (at 3:08:53 and 3:36:37 in the video).
Futurization is not the result of the particular regulations crafted by the CFTC. It is a result of the overarching goals of Title VII of Dodd-Frank, and the unacknowledged fact that the vast majority of swaps are economically the same as exchange-traded futures type contracts. Title VII imposes 3 new requirements on the OTC swap markets: (i) universal supervision, which means all swaps are subject to regulation and oversight, (ii) transparency, which means standardized and standardizable swaps trade on exchange-type venues, and (iii) clearing for all standardized and standardizable instruments. Once these 3 things are done, standardized and standardizable swaps become virtually indistinguishable from futures type contracts.
The Dodd-Frank Act could have explicitly mandated that all standardized and standardizable swaps move over to the exchange-traded futures model. But it didn’t. Instead, it set up a parallel regulatory framework for OTC swaps, complete with their own type of exchanges and clearing regulations and so on. So the CFTC is tasked with defining regulations for swaps covering all of the same sorts of issues that it already has regulations for in the futures marketplace. In crafting this parallel set of regulation, however, the CFTC is still mandated by Congress to assure transparency and clearing as feasible.
So long long as the CFTC sticks to the Congressional intent on the big issues — supervision, transparency and clearing — the main difference between the futures marketplace and the swaps marketplace disappears. On these 3 big issues there can be no regulatory arbitrage.
What remains are small differences in the details of how these large goals are executed — differences in how margins are calculated, margin levels, calculations of position limits, reporting standards and so on. And, because the CFTC is crafting an entire parallel apparatus for swaps de novo, there is also an inherent difference in uncertainty as the swaps apparatus gradually takes shape. On these subsidiary issues there will be regulatory arbitrage.
Whose fault is this?
I look first and foremost to the swaps industry, which has marketed a false picture of its own products. It has tried to advertise swaps as uniquely custom designed products, inherently different from futures. This is true for a small, but vital portion of swap products. But it is decidedly false for the vast majority of swaps. It needed to market this false picture in order to justify the parallel regulatory apparatus it hoped could preserve its control of the market in standardized and standardizable derivatives.
Now, as the rules begin to bite, everyone is surprised that a large portion of the swaps market is shifting over to futures. Congress did not expect that to happen, but only because Congress was sold a bill of goods by the swaps industry.
Once we acknowledge that the swaps industry sells (i) a small number of customized derivatives, and (ii) a large number of standardized and standardizable derivatives which are economically identical to futures-type contracts, the question of futurization can be looked at in a very different light.
First, futurization of the standardized swaps is no problem for society. The regulatory arbitrage we are seeing is not a problem for society.
Second, we will be better served by focusing our attention on crafting rules for the swap market that are well suited to the customized products that only the swaps market can offer. Then society gets the best of both worlds — good regs for the standardized instruments trading in the futures model, and good regs for the customized instruments trading in the swaps model.