Category Archives: regulation

Futurization wheat and chaff


Finally, a journalist has located a real cost of futurization, as opposed to the many imagined ones.


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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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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Prop-Flow stands convicted, too.

The trial of UBS trader Kweku Adoboli ended yesterday with his conviction on two counts of fraud and the dismissal of the accounting allegations. Some news accounts have noted that testimony at the trial also exposed embarrassingly shoddy risk management at UBS. Prop-flow also stands convicted.

Prop-flow is one of those wonderful neologisms of the investment banking world. UBS’s Delta One desk, where Kweku Adoboli was employed, is a classic example of the prop-flow trading model. Ostensibly, a Delta One desk is serving customers, manufacturing risk exposures that the clients want, and earning revenue for providing that service. But the testimony at Adoboli’s trial leaves no doubt that his assignment was proprietary trading, pure and simple. He wasn’t convicted because he did prop trading, but because of how he did his prop trading. The testimony leaves no doubt that his UBS managers always expected him to be placing proprietary trading bets. The only dispute was about how those bets were managed and recorded, and the scale of the bets along the way.

How much tolerance bank Boards of Directors and bank regulators have for neologisms like prop-flow will be an important question in the coming years as the Volcker Rule and similar prohibitions come into force.

SEC Staff examines copper ETFs with blinders on

The SEC is currently considering whether to allow JP Morgan and Blackrock to list new copper ETF’s on the NYSE Arca. Some copper industry players oppose the listing, as does U.S. Senator Carl Levin and the advocacy group Americans for Financial Reform. Comment letters can be found here. Earlier this month, SEC Staff in the Division of Risk, Strategy, and Financial Innovation filed a memo reporting its empirical analysis that downplays any potential problem. That memo is a testament to how America’s financial regulators too often fail in their duty to protect the sound functioning of US financial markets.

The SEC staff asks two narrow questions.

First, is there a simple and enduring mechanical link between the flow of money into a commodity ETF and the price of copper. They answer, ‘no.’

Second, is there a simple linear relationship between copper inventories and copper prices. Again, they answer, ‘no.’

The Staff’s analysis is faulty in many ways. Both industry players and the advocacy group Americans for Financial Reform filed careful, detailed critiques of the econometrics and reasoning. These are well worth reading, and thoroughly impugn the soundness of the Staff’s conclusions.

What alarms me most is the narrow scope of the questions that the Staff posed, even had they bothered to do a thorough analysis of those questions. A proper regulator needs to assure that the market functions well. There are any number of ways in which its operation can be disrupted. We have a long, long history of commodity markets in the US, and that means we have a long history with market manipulation and other price distortions. We have a long, long history with financial markets in the US, and that means we have many experiences with asset bubbles, especially in the recent past with the dotcom and housing bubbles, as well as the oil price bubble. Neither of the two empirical tests the SEC Staff examined touches in any way on the issues one would want to examine in order to assure the sound functioning of the copper market and the healthy contribution that financial trading could make to the market. The mechanical link the Staff searched for would not show up in a market rife with manipulation. Nor is that mechanical link necessarily symptomatic of an asset price bubble. So failing to find such a link provides no assurances that this market will function properly. And it is alarming that the SEC Staff does not explore any of these other important issues that must be settled. Just as the SEC Staff did in the Madoff case, it carefully asks the wrong questions and thereby comes to easy answers.

Personally, I’m confident that financial markets have a valuable contribution to make in extending the efficiency and productivity of the real economy. I believe that’s true for all commodity markets as well, copper included. But making that happen requires active engagement by US regulators, and not a ‘see no evil’, hands off, laissez faire approach. That way lies market disruption and an undermining of the productivity of the economy.

The SEC can do better. It must. American industry depends on it.

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.


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

Moody’s Slips on ICE

As reported by Platts, Moody’s recently issued an analysis of the decision by ICE, the Intercontinental Exchange, that starting January 2013 its cleared OTC energy swap products would switchover and be traded as futures products. Moody’s called that “credit negative for power producers.”[1]

There are many things wrong with the Moody’s analysis. Continue reading

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