Wednesday, January 30, 2013

When it Comes to Swaps, Futurization Means Innovation

“Given the inconsistency in the Commission’s interpretation of its own rules, the lack of regulatory certainty and the increased cost of compliance with the Commission swaps regulations, including the complicated and controversial swap dealer definition rules, swap customers have turned to futures markets for regulatory certainty. ICE will become the first exchange to take such a step ahead of new financial regulations, but I suspect they will not be the last.”--CFTC commissioner Scott O’Malia, September 27, 2012

 As new regulations under Dodd-Frank move swaps from the OTC swaps marketplace into the futures marketplace, exchanges and swap participants have come up with new products that trade as futures, but provide the benefits of swaps transactions. They have also begun to devise swap products that are custom designed, and therefore ill-suited to exchange trading and clearing, and thus are exempt from the new regulations.  Futurization, the movement of swaps from the OTC derivatives marketplace into the futures marketplace, has not led to the end of swaps, but to a small renaissance of financial innovation.

Prior to its regulation under Dodd-Frank, the OTC swaps markets were opaque, had very limited regulatory oversight, and lacked central clearing requirements.  Not surprisingly, most - if not all - swaps players chose to execute their swaps transactions in the OTC derivatives market.   Once Dodd-Frank came along, the OTC swaps marketplace was transformed into one subject to regulatory oversight, with new rules requiring transparency and central clearing of most swaps, except for the highly customized kind.  With this new oversight and market structure, however, ended many of the functional and financial advantages of trading swaps over the counter.  

This transformation from the virtually lawless land of the OTC swaps marketplace is not taking place all at once, however. Dodd-Frank is a ponderous piece of legislation that parcels out regulatory responsibilities to a host of regulators.  In the case of swaps and futures, the responsibilities rest with the SEC and CFTC, who divvied up the swaps and futures market regulation between them.  This has led to a sometimes piecemeal or phased implementation of the new regulatory regimes, and some considerable uncertainty on the part of swaps participants.  In fact, to quell some of this uncertainty, the CFTC will hold a public roundtable on the topic on January 31, 2012.

The end of many of the advantages previously enjoyed in the OTC swaps markets, coupled with the uncertainty about some aspects of the regulation of the new swaps regime has driven many into the more established futures markets seeking products that will give them the benefits of swaps under the futures regulatory structure.  Exchanges have been mindful of this demand and are devising clever swap-future hybrids to trade on the futures platforms.  

Some are taking vanilla swaps and merely transferring them to the futures trading platform.  Just this month, ICE announced that all of its cleared OTC energy swap products would be traded as futures products.  While it is likely that almost all kinds of interest rate, foreign exchange, and non-energy commodity swap transactions could be similarly substituted with plain vanilla futures and option contracts, not all kinds of swaps can.  

Enter the swap-future hybrid.  Swap futures are attempts to trade swaps, but do so under the futures regulatory regime.   CME has come up with an interest rate swap future product, which is essentially a futures contract with a traditional interest rate futures contract as an underlying product. CME says that this method has an added advantage of actually being cheaper than a traditional interest rate swap because traders can offset their margin used to back their swap futures contracts against margins they may have set up at the CME clearinghouse to back other futures contracts, reducing their overall margin requirements.   CME also touts these products as ones that eliminate bank counterparty credit risk and are much more liquid than OTC derivatives.  Eris is offering a similar swap future product, but Eris's hybrid product does not make the underlying product an actual swap. Rather, Eris cash settles its swap future contract to mimic an OTC swap.

Exchanges and swaps participants have taken a stab at having the best of both the freedom of the OTC swaps marketplace and the safe and predictable futures and options markets. Innovations like swap futures thus far seem to be filling some needs in the swaps marketplace.  In the long run, continued innovation may also provide some efficiencies and benefits that were unavailable in the unregulated wild west of the pre-Dodd-Frank OTC swaps markets.