Today, the CFTC is hosting a Roundtable on the “Futurization of Swaps.” More than 30 people from various parts of the industry are speaking. I’m on the first panel. Here are 3 points I’ll be making:
1. They’re all just derivatives.
Before the financial crisis, before Dodd-Frank, the OTC swaps market encouraged a myth about itself. That swaps were different from futures. Swaps were special. Swaps are all about customization, unlike those clunky futures contracts.
Like many other myths, there was a kernel of truth about it. A small segment of the swaps market is about customization, about innovation, about thinly traded risks. But that was far from the whole story.
The pre-crisis OTC swaps regime provided a space for customization by being outside of the futures regulatory regime, which did enforce standardization. But once the loophole of no regulation existed, a huge volume of trade in standardized and standardizable risks wanted the benefit of evading the regulations. The trade in those standardized and standardizable risks represent the vast majority of OTC swaps.
Now that some of those standardized trades have moved to the futures markets, that myth is busted. We’re here because the swaps industry doesn’t want to see the rest of the standardized and standardizable risk trades move over to futures, too.
Now we all have to admit that a standardized derivative is just a standardized derivative. You can manufacture it and slap the label “swap” on it, or you can slap the label “future” on it. From an economic standpoint, as far as constructing a financial instrument that trades this or that risk, there is no difference.
2. Dodd-Frank leveled the playing field.
In the current debate about futurization, some are demanding that the regulators revisit the rules to “level the playing field” between swaps and futures. They’re talking about things like block trade rules and such.
Let’s step back and look at the big picture. We’re all here, and futurization is an issue because the Dodd-Frank Act already did level the playing field.
Before the crisis and Dodd-Frank, the futures market and the OTC swaps market had markedly different regulations and modes of conduct.
- Futures were regulated, swaps were not.
- Futures market were largely “lit”. Swaps markets were largely “dark”.
- Futures were cleared. Swaps were often not.
Those were three very major differences. But now they are largely gone thanks to Dodd-Frank and the work of the CFTC and others to implement it.
- Swaps are now regulated,
- Most of the swaps market must become “lit” and
- most swaps must be cleared.
Now that the major differences between the two markets have been erased, trade is rethinking whether it should be channeled to the futures market.
With those big differences out of the way, attention has now turned to the smaller details, as when a carpenter crafting a piece of furniture shifts from sanding with rough grain paper and moves to finer and finer grain sandpaper.
3. Keep your eye on the ball.
The slogan “level playing field” rings good. But it may not be a good or reliable guide for rulemaking action. I’m not sure it is a viable long-run strategy to pursue leveling the playing field too far and in every respect. It’s not clear to me that it’s even feasible to constantly and meticulously hunt down any and all regulatory distinctions between swaps and futures regimes.
Think about what that strategy means. It tasks the CFTC with managing separate regulations for two different marketplaces, and then re-tasks the CFTC with ensuring that the separate regulations are actually identical in all their detail. First it spends its time building up a distinct regime, and then it spends its time erasing any distinctions. Was there ever a more straightforwardly Sisyphean task?
If a thoroughly leveled playing field were really the objective, wouldn’t it be better and simpler to just have one regime?
An alternative way to approach the rulemaking endeavor is to think of the two marketplaces as serving different needs for derivative trading. Perhaps the futures marketplace is best for standardized risks with significant liquidity and many diverse traders. Clearly the swaps regulatory regime is the only one that specifically accommodates customized swpas, and maybe the swaps marketplace is best suited for innovative or illiquid instruments or those dominated by a small set of traders. I don’t come into this with a clear and definitive view on the right sorting. But if the CFTC has been tasked with overseeing the rules and regulations for two different marketplaces, it seems to me that it is because there are important differences between the two markets which need to be respected as the rules are crafted.
The slogan “level the playing field” doesn’t fit the bill. It’s not practical, and it is ill suited to the important task at hand, which is providing American businesses with two well functioning marketplaces, each serving a distinct need.
The old, pre-crisis regime drew the boundary between the two marketplaces in the wrong place and the wrong way. The Dodd-Frank Act re-imposed 3 key principles necessary to assure stability in both marketplaces. But having assured that both markets function safely by respecting those 3 key principles, there may remain finer differences that are valuable to American business and that should be respected.