Guest commentary by Jim Falvey.
Jim Falvey, general counsel for Green Key Markets, has been an attorney in the derivatives space for over 15 years. He has served as general counsel of Eurex US and IntercontinentalExchange, as assistant general counsel for CME Group and, more recently, as general counsel and corporate secretary of R.J. O’Brien & Associates, a Chicago-based futures commission merchant. He also sits on the advisory board of CMDirect, a web-based commodity trading platform. His regulatory column appears weekly in Green Key Markets’ ethanol research newsletter. To subscribe to the newsletter click HERE.
Since the passage of the Dodd-Frank Act, almost exactly three years ago, we are still caught in a debate over the intent of the law. Was it meant to futurize the swaps world or swapify the futures world? (at the very least, it’s tortured the English language by allowing writers, myself included, to use word endings “ize” and “ify” and “tion” too often).
I initially agreed with those commentators who argued that Dodd-Frank was futurizing the derivatives market. There was ample evidence to support this proposition. In particular, the Commodity Futures Trading Commission (“CFTC”) did not issue the final Swap Execution Facility (“SEF”) rules for over two-years from the passage of the law. As you may recall, in the post-Dodd-Frank world, all standardized swaps (most of the swaps world) have to be executed on a SEF or a Designated Contract Market (“DCM”), cleared at a Derivatives Clearing Organization (“DCO”) and reported to the marketplace via a Swap Data Repository (“SDR”). Because the CFTC delayed in issuing SEF regulations, DCMs, like the Chicago Mercantile Exchange (“CME”) and the IntercontinentalExchange (“ICE”), had huge head starts to establish their respective businesses. Thus, one point scored for futurization.
The CFTC issued other rules that favored futures exchanges (DCMs) over SEFs, such as those relating to block trades and margin. Specifically, as to block trades, a DCM is able to set the tradable size limits, whereas a SEF must follow a formula established by the CFTC to determine the proper size for a block. Additionally, futures exchanges have other authority to determine block characteristics that SEFs were not granted. Another point for futurization.
With respect to margin, a market participant is required to post significantly more margin to enter into a swap transaction on a SEF as compared to an economically similar (if not identical) future on a DCM. Score another for futurization.
While futures must be — and are — publicly reported, swaps are subject to fairly onerous reporting rules that resemble a ticker tape, according to the Chairman of the CFTC, Gary Gensler. It’s unclear how much different this process ultimately will be from futures reporting, but it initially appears that swaps will be subject to a different and more stringent reporting regime. Also, at least as to blocks, there is a delay allowed in reporting time (and understandably so), but non-blocked swaps must be reported as soon as practical. Futurization is shutting out swapification.
Lastly, there is an anti-competition issue to consider. For the most part, futures exchanges have their own captive clearing houses. Thus, clearing is part of a vertical model that has made futures exchanges valuable commodities (pun intended) on Wall Street. Open interest (“OI”) resides at a captive clearinghouse because of the trades that occurred on its related exchange (e.g., CME Group trades are cleared and maintained as OI at the CME Clearing House, which is a separate division of CME Group). OI is protected from commingling by rule of the clearinghouse and sometimes through contractual arrangement with the futures exchange. A captive clearinghouse of a futures exchange can decide to do business (or not) with whomever it pleases. While it’s not uncommon for a clearinghouse to agree to clear another futures exchange’s non-competitive product, the clearinghouse is not required to do so. The open interest of the other exchange’s contracts is kept in a separate pool within the clearinghouse. Thus, futures exchanges are allowed to put up moats around their open interest.
In the newly developed SEF world, it has been mandated that clearing houses must accept for clearing a competitors swap product, as long as it passes certain criteria as established by the risk committee of the clearing house, etc. So, theoretically, ICE could go to CME clearing and ask that one of its interest rate swap contracts be cleared at CME – and CME cannot decline (absent a legitimate reason – and not wanting to do business with ICE is not legitimate).
What is the effect of this factor, then? I believe it once again favors futurization. While the rules mandate that a clearing house cannot deny a SEF clearing, the practical reality is that a SEF will have a difficult time finding a clearing house for any products it offers that compete with the clearing house’s vertically integrated exchange.
So, futurization wins in a landslide, right? Well, maybe not. If we listen to Commission Bart Chilton, we have reason to be wary:
While I’m interested in hearing the concerns about futurization, I am more concerned about…a silent creeper. That is, the “swapification” of the futures markets. Specifically, I’m concerned that the conversion of certain standardized cleared swaps will be under-regulated7in the futures markets. It may be block rules or something else, but we need to be cautious about converting certain swaps to futures in an attempt to export the deregulated, opaque swaps trading model to these new futures markets. Let’s be cautious about allowing lax oversight of these futures contracts, regardless of how they were treated before they were futurized.
What is going on here? Commissioner Chilton and perhaps others at the CFTC are using the term “swapification” for code that means: create new rules for the futures markets that are based on the recently enacted, and more stringent, swap rules. In other words, there may be a desire to not only regulate the previously unregulated swaps market, but to use Dodd-Frank as the weapon to re-regulate the futures market. The vision, apparently, is to take away much of the discretion that has been afforded to futures exchanges throughout the years, most notably beginning in 2000 with the Commodity Futures Modernization Act. The exchanges and most market participants will uniformly line up against a full-scale assault on the futures industry, which may be what’s at issue here. It has been conceded time and time again by proponents of regulation that the futures market did not fail in the Great Recession of 2008. Not only did the futures industry not fail, but the objective of Dodd-Frank was/is not to re-regulate this market. Doing so will only raise the cost of hedging for everyone that ends up being paid for by consumers.