Category Archives: OTC reform

Congressional Intent & Futurization

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.

House Hearing

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.

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How Futures Can Steal Market Share from Customized Swaps

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Many people underestimate the threat that futures markets pose for the OTC swaps industry because they have been suckered into thinking of swaps as carefully custom tailored instruments. It’s true that a small fraction of the OTC swaps market cannot be replicated in the futures marketplace. And it is good that the Dodd-Frank Act preserved a space for customized swaps. But the vast majority of swaps are not custom tailored, or the custom tailoring is so inconsequential that it will be an easy matter for the futures market to serve the same purpose.

Even when the swap does contain some important element of customization, that is usually not the whole story. Many customized swaps can be broken up into 2 pieces: (i) a basic, plain vanilla swap, plus (ii) a small bit of customization that adapts the plain vanilla swap around the edges. The futures market can substitute for the plain vanilla swap, and then the OTC swap market can provide the customization around the edges.

It’s like buying a suit ready-to-wear, but having the tailor adjust the hems or waistline a little bit. So long as the adjustments are small, its an economic alternative to true customization.

An illustration of how a custom swap can be broken up into two pieces appears in an article by Sean Owen, Director of Fixed Income Research and Consulting at Woodbine Associates, published in a recent special issue of the Review of Futures Markets. He breaks up an irregularly amortizing 10-year interest rate swap into (i) a 7-year bullet interest rate swap, and (ii) a customized swap that produces the irregular amortization relative to the 7-year bullet. (H/T to CFTC Commissioner Scott O’Malia for highlighting the article)

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Futurization advances in interest rate products

The NYSE Liffe is moving to adapt their futures products to grab more business away from the OTC swaps market. It announced changes yesterday to enable large block trading in 3 of its products–three month Euribor futures, three month sterling futures and long gilt futures. The block trades will be handled on its Bclear system. The service is scheduled to be available starting December 10.

The FT’s coverage is here. It will be interesting to see how the new service does and how it affects the overall flow of trade in those futures contracts.

This looks to me like another example of the futures marketplace easily being expanded to offer a service in standardized derivatives formerly performed OTC. There was never any special economic rationale for this business in standardized derivatives being handled OTC. This move exposes, once again, the fallacy that the OTC swaps market was dominated by customized products that are ill-suited to standardized markets like futures exchanges.

Futurization #4 — an agenda item for the CFTC hearing

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?

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Futurization #3 — long live innovation and customization

Defenders of the OTC swaps model like to talk a lot about the ability to custom tailor the terms of a swap to each customer’s particular needs, and also about the room given to innovate new product designs. The listed futures exchange model cannot accommodate this degree of innovation and customization. That’s true, as far as it goes.

Fortunately, the Dodd-Frank OTC derivative reforms preserve a space for this element of the OTC swaps model. Customized swaps are still allowed. Swaps that implement new product designs are still allowed. Exchange trading is not mandatory for all swaps. Clearing is not mandatory for all swaps.

When we talk about futurization of swaps, we are talking about the larger subset of swaps that are either already marketed as off-the-rack products, or that can be easily repackaged as such. This represents the vast majority of OTC swap trading.

Dodd-Frank was architected to allow standardized derivative trading either on the newly created swap exchanges or on the pre-existing futures exchanges. The current talk about futurization is all about the choices being made for trading these standardized derivatives. Instead of transitioning onto swap exchanges, they are moving out of the swaps marketplace and onto the futures marketplace. Customized derivatives will have to continue to be offered as swaps, which Dodd-Frank explicitly allows.

Moving standardized derivatives onto exchanges, and clearing those transactions can benefit customers. There is a lot to be gained from encouraging efficiency and product development in ready-to-wear derivatives.

Artisinal production has its benefits, but mass production does, too. The Dodd-Frank reform permits both.

It never hurts to check the data

This coming Friday the CFTC will be hosting a Research Conference on derivatives markets. The agenda touches on HFT, swaps market structure and the financialization of commodities.

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Futurization #2 – why?

Why Futurize Swaps?

Futurization is the movement of derivative trades out of the OTC swaps marketplace and into the futures marketplace. There are different ways in which this shift may take place. Economically, they all have one thing in common: a recognition that there is in fact nothing special about swaps as a financial instrument. In general, any package of risk that can be structured via a swap can also be structured using futures and options contracts that can be traded in the futures marketplace.

The essential distinction between the OTC swaps marketplace and the futures marketplace is the regulatory rules, not the product designs that can be offered. Of course, a difference in regulatory rules can be economically significant, too. But it is important to keep straight the real source of any economic impact.

Prior to the Dodd-Frank Act, the OTC swaps marketplace lacked regulatory oversight, transparency and clearing, and the vast majority of derivative trades were executed in this marketplace as a result. After the Dodd-Frank Act, all OTC swaps trades are subject to regulatory oversight, and the vast majority must be traded transparently and cleared. There are exceptions that allow the OTC swaps market to continue offering swaps that are custom designed, and therefore ill-suited to exchange trading and clearing. However, for the vast majority of swaps, the Dodd-Frank Act removed the main advantage of the OTC swaps marketplace. With the mandates of oversight, transparency and clearing, the main raison d’être is gone.

Consequently, all players in the industry are now reassessing the choice of venue for derivatives trades: the OTC swaps market or the futures market. When the new calculus leads them out of swaps and into futures, that is the essence of the futurization of swaps.

How is the futurization of swaps to take place? I group the different ways into two main categories.

First, in many cases, plain vanilla futures and option contracts can easily substitute for swaps.

This is exemplified by the recent decision by the ICE to simply switch its cleared energy swaps into futures contracts. There was more to it than simply changing the package label, but not much more. ICE’s cleared energy swaps may be a special case for the ease with which such a transition can be executed, but from an economic standpoint it is much more representative than is yet widely recognized.

The vast majority of interest rate and foreign exchange swap transaction could be readily supplanted by plain vanilla futures and option contracts, as can other commodity swaps. For example, the CME’s IMM has long offered interest rate and currency futures which serve the same risk packaging function as interest rate and currency swaps. But these products were overshadowed by the OTC swaps marketplace because that marketplace had the advantage of not being regulated. Now that the Dodd-Frank Act has imposed comparable regulatory rules which remove the advantage of the OTC marketplace, these products may once again come out from under the shadow of the OTC and steal back the business. That hasn’t happened yet. But be patient.

A second, more contorted category involves attempts to somehow trade swaps, but to do it under the futures regulatory rules. These are the so-called “swap futures”. One example comes from the CME, which, in September, announced plans to launch its interest rate swap futures product. This is a futures contract where the underlying product is a traditional interest rate futures contract. So long as the customer owns the futures contract, the margining and other regulatory rules of the futures exchange apply. But, if the contract is held to delivery, then the customer finds itself holding an OTC swap, and the margining and regulatory rules of the OTC swaps marketplace then apply. Another example comes from the upstart Eris Exchange, which launched its interest rate swap futures product back in 2010. Instead of making the underlying product an actual swap, Eris cash settles its futures product to mimic those on an OTC swap.

This second category has all the buzz, currently. But perhaps not for long. The push for this second category is predicated on the idea that it is possible to have the best of both worlds—the current regulatory arbitrage benefits of the futures marketplace along with the economic advantages of swaps. But there never were any special economic advantages of swaps, so the underlying rationale for swap futures is faulty. After the buzz dies down, and the players recognize the problem, the action may turn back to the first category. On that, we are still waiting. Be patient.

Fear of the Future-ization of Swaps #1

The reform of the derivatives market, like other parts of financial reform, has been a very slow moving process. As when a giant ocean tanker is being slowly turned around, progress is so slow that it can be hard for the naked eye to confirm that the event is actually happening until the great ship’s silhouette overtakes a distinctive landmark on the horizon. And derivatives market reform, too, is happening. Each time the reform slowly approaches a new landmark on the horizon, the fact of reform is confirmed once again to proponents and opponents alike. And each time this happens, there are new howls from opponents that the ship’s current course will surely lead to disaster.

The current occasion for complaints goes under the heading “futurization of swaps.” Pre-reform, derivatives could either be traded in regulated marketplaces, generally called futures markets, or in the un-regulated marketplaces, generally called the OTC swaps market. The Dodd-Frank Act brought regulation to the OTC swaps market. Those regulations are only now beginning to take effect, or the deadlines are approaching. As that happens, companies on all sides of the derivatives markets are beginning to rethink where they should do their derivatives business. Should they continue to trade swaps, or can they get the same result using futures? Should they continue to market swaps, or should they now market futures? The swaps marketplace used to have the advantage of being unregulated, but as that advantage appears to be disappearing, where is the rationale for swaps? Derivative consumers and producers alike are giving the futures markets a fresh look. Some swap products have been relabeled and moved over to futures markets. Other, new futures products are being developed as substitutes for old swap products.

Obviously a major shift of business from the swaps market to futures markets threatens major business interests. Throughout the legislative battles leading up to Dodd-Frank, and the rulemaking and legislative battles surrounding implementation, the big banks that controlled and profited from the OTC swaps market hoped to preserve their monopoly. So far, they have mostly failed. The current debate about the ‘futurization of swaps’ is a major milestone in the process, and it is no surprise that it is raising new howls. These interests are complaining that the legislation is killing the swaps market, ruining a valuable financial innovation.

In the coming days, I will look at various arguments being made against the futurization of swaps. None of them hold up.

You say ‘futures’ like it’s a bad thing.

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.

Why?

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.

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Moody’s correction

Moody’s issued a correction today.[1] It had previously tagged as ‘credit negative’ for energy companies, the decision by ICE to move many of its cleared energy OTC swap contracts over to its futures exchange platform. Now Moody’s recognizes that as ‘credit neutral.’ Platt’s coverage is here. Continue reading

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