Under Dodd-Frank, swaps will be cleared and subject to reporting requirements, and traded over swap execution facilities (SEFs), the precise rules for which are still being ironed out. However, contrary to the intended aims of Dodd-Frank of protecting end-users by increasing transparency and reducing risk in the swaps markets, some believe the legislation as it stands is likely to encourage the “futurization” of the swap market, a move that could increase investors’ exposure to risk.
The move away from using the customized over-the-counter (OTC) swaps market towards the standardized futures market has come as a result of differences between the proposed treatment of swaps and futures by the US Commodity Futures Trading Commission (CFTC), which is responsible for regulating both markets.
Under the proposed rules, swaps will be set on a minimum initial margin based on five days trading, against just one day for futures. That means that the price of margin for swaps over futures will at least double.
Banks will pass that additional cost on to customers, meaning wider swap spreads for end-users.
Futures exchanges have been quick to capitalize on this anomaly, with firms such as ICE offering swap futures. These products start trading on a futures exchange, and therefore benefit from reduced margin requirements, but clear to a swap at maturity.
It is not just the differing treatment of margin requirements that favour futures over swaps, but also reporting requirements.
With new rules requiring swap deals to be reported to the market within a time limit, market makers, especially in more illiquid markets, will have to either quickly cover their customers’ positions in the market or take them on to their books over the long term.
Either way, that means wider spreads for customers in the swap market.
Furthermore, reporting requirements for swaps dealt over SEFs under the new rules are likely to be more exacting than those for futures exchanges, which can set their own minimum block trade limits.
By setting low levels for what are considered block trades, which can bypass normal price transparency and reporting rules, futures exchanges can therefore encourage investors to shift away from using swaps to using swap futures.
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| Wayne Pestone, chief regulatory officer at FXall |
Wayne Pestone, chief regulatory officer at FXall – a trading platform which has plans to become an SEF once the rules are finalized by the CFTC – believes swaps and swap futures should be treated the same way under any future legislation, and that there should be no room for regulatory arbitrage under the new rules. “Margin and block requirements mean the deck is stacked against swaps right now,” he says. “Economically equivalent, swaps and futures should operate under the same rules, whatever they happen to be called.”
The problem for investors is that although it might be cheaper to hedge exposure through futures, the standardized nature of the market means that achieving the protection they can get through swaps is more difficult.
One US chemical producer, for example, estimates it needs to execute about 150 trades in the OTC swaps market to cover its risk for a year. The firm told a conference earlier this year it estimates that if it had to cover that risk in the futures market it would need to transact 144,000 trades.
That might seem like an extreme example, but take a simpler example of a company that wants to hedge its exposure in the FX market of a foreign currency payment it will receive in say 42 days.
In the OTC swap market that risk is relatively easy to cover. However, in the futures market, the likelihood is that listed contracts will only be available for liquid periods such as 30 or 60 days. So, faced with rising swap prices, a company might choose just to cover its risk for 30 days.
By using futures instead of swaps, in other words, there is a danger that investors leave risks un-hedged.
That runs against the intention of the regulation to protect the end-users of swap products. Indeed, it pushes the risk back on to the segment of the market – for example, corporations – that are least capable of absorbing the risk.
That is not to say swap markets aren’t in need of a regulatory overhaul, it is just that, as Pestone puts it, the CFTC needs to be mindful of the unintended consequences of some of the proposed changes and the potentially harmful implications that the futurization of swaps could have on the end-users of the products.
“We are calling for a moratorium on swap futures products until the SEF rules are passed,” says Pestone. “Otherwise there might not be meaningful swaps volume left to trade by the time SEFs are up and running.”
It might be time for the end-users of swaps, such as corporations and asset managers, to engage with regulators before it is too late.