Early last month, the Intercontinental Exchange (ICE) announced that it was transitioning its cleared energy swaps products into futures products. That move precipitated a chain of commentary warning that other swaps business might soon transition to the futures markets. The blame is placed on various alleged problems with the CFTC’s rulemaking for swaps. CFTC Commissioner Scott O’Malia is a prominent voice making this argument recently.
What if this switch is a feature and not a bug?
Once upon a time, all derivatives trading was regulated, with transactions taking place on an exchange and with positions cleared and margins posted. Then along came the OTC swaps market, which grew enormously, far surpassing the futures markets.
Many champions of the swaps industry point to flexibility as a major advantage of swaps—the terms of a swap can be tailored to each customer’s needs. Futures, because they must be standardized, are too inflexible.
There is a grain of truth in this, around which is spun a giant ball of misrepresentation.
ICE’s move exposed the duplicity in the argument made by these champions. All of ICE’s cleared energy swaps were already standardized in the same way that a futures product needs to be; that is why they could be readily repackaged as futures. Important market players, however, misunderstood this action because they had been taken in by the duplicity in the champion’s argument–see here and here.
Not all swaps can be transformed into futures just by relabeling them, as ICE’s cleared energy swaps were. But, the vast majority of OTC swaps transactions could, with adjustments, be successfully executed as futures products. Only a small minority of swap transactions are custom tailored and unsuitable for exchange trading and clearing.
Until 2008, the real reasons that so many contracts are packaged as swaps are (i) swaps used to be unregulated, which served many different purposes, and (ii) the dealers ran an opaque market over which they exercised significant control and which generated good profits.
Enter Dodd-Frank… Now all swaps trading is to be regulated, all transactions must be reported, the majority of transactions must be standardized, traded on exchanges and cleared. Suddenly the main raison d’être for swaps as swaps is gone. There is still a place for customized swaps, which could not be easily traded on an exchange nor cleared. But this represents a small minority of the market.
For the past three years, as the Dodd-Frank Act was being negotiated and subsequently as its provisions were being translated into detailed rules, much effort has been expended trying to design a complete swap regulatory apparatus parallel to the futures regulatory apparatus guided by the fundamental error in thinking that swaps were truly different. Incumbent players tried to influence the process to preserve their domain, and the illusion that swaps were different was key to their ability to convince everyone else to play along. But so long as the Dodd-Frank Act preserved the fundamental principles of (i) universal oversight, (ii) transparency in trading, and (iii) clearing, the illusion was sooner or later going to be punctured. That is now beginning to happen. It is a demonstration that the rulemaking process to date has succeeded in one important thing: despite all of the problems, the industry has failed to succeed in getting rules through that undermine those three fundamental principles.
ICE’s move is a harbinger. More will follow, as Commissioner O’Malia rightly predicts. But the fault lies not in the mismanagement of the swaps rulemaking process. Instead of wringing our hands, complaining that this is a sign of a problem, we should be celebrating that the move has finally begun.
Update: Commissioner O’Mallia has clarified to me that he takes no stand, whether in favor or against, regarding a swap product moving over to be sold as a futures product. But he is concerned that this not happen as a result of problems in the rulemaking process for swaps.