Bloomberg’s legal action against the Commodity Futures Trading Commission (CFTC) this week will not constrain the growth of swap futures, experts have warned.
The lawsuit, filed Tuesday in a federal court in Washington DC, relates to the lower initial margin payment required for swap futures compared to cleared swaps, which the firm believes will limit liquidity on swap execution facilities (SEFs), the OTC trading platforms created by Dodd-Frank.
Listed futures typically require margin based on one-day value-at-risk (VaR) calculation, while for cleared swaps margin is based on a five-day VaR under preliminary CFTC rules, raising the cost for institutional investors that use the instruments for hedging purposes.
The need to report swap trades to swap data repositories is also a concern of Bloomberg, as no such requirement exists for futures products. Bloomberg intends to launch a swap execution facility (SEF) when CFTC rules are finally released.
Since October, three US futures exchange operators – IntercontinentalExchange, CME and Eris Exchange – have developed and launched futures that mimic standardised swaps instruments to wrest market share from swaps instruments.
Data from the CME show their 10-year USD deliverable interest rate swap future traded 18,412 contracts for the week ending Friday 12 April, while 5-year USD deliverable interest rate swap futures traded 13,056 contracts.
Charley Cooper, senior managing director, State Street Global Markets, which, like Bloomberg, is awaiting SEFs rules before it can launch its SwapEx SEF, said the rise of swap futures would continue.
“There is definitely going to be a significant shift from swaps to futures, but it will not be a complete migration of volume. The market has clearly shown there is already growing appetite for swap futures,” Cooper said.
In a statement released after the lawsuit was filed, Bloomberg said it had acted on behalf of its buy- and sell-side clients to ensure this “flawed regulation” was not implemented.
In an opinion article published on Tuesday, Daniel L. Doctoroff, Bloomberg CEO, said by leaving this margin difference in the rules, the CFTC would harm the market and that the trend toward futures was not occurring organically.
“In response to the CFTC’s rule, a market phenomenon called ‘forced futurisation’ has taken place, whereby market participants are simply re-labelling a swap as a future. This in turn has led to less transparency, less ability for market participants to access data, and more risk to retail investors,” Doctoroff wrote.
Unpredicted outcomes
However, Cooper believes the rise of swap futures should have been predicted by the market, and cites State Street’s alignment with Eris Exchange – one of the US venues offering swap futures – as evidence of planning for the growth of futures. State Street has a licencing arrangement with the exchange as its platform uses their technology and clearing services.
Despite this, Cooper is concerned of another possible outcome of Dodd-Frank’s Title VII rules – that mandate the central clearing of the more standard swaps – namely that the more exotic instruments, which traditionally carry more risk, will be more appealing to institutional investors.
Despite this, Cooper is concerned of another possible outcome of Dodd-Frank’s Title VII rules. He believes more exotic instruments may become more attract to market participants as they fall outside of Dodd-Frank rules and the global standards under Basel and IOSCO that require 10-day VaR will not hit until 2015, opening the door to regulatory arbitrage.
“All regulators should be wary of creating a situation where non-cleared swaps – the more bespoke instruments – become more appealing to market participants as the aims of reducing systemic risk outlined in Dodd-Frank and by the G-20 will not be met,” Cooper said.
While there is a need to create a broadly level playing field between swaps and futures, there may not be a need for rules to be overly prescriptive in establishing equality.
“There will be some element of risk transfer from swaps to futures, so rules must be effective, not necessarily equal or identical,” believes Sean Owens, director of fixed income and derivatives at financial consultancy Woodbine Associates. “The final rules must achieve the overall aims of reducing systemic risk, increasing transparency and establishing clear rules for trading,” Owens added.
Owens said the rise of swap futures was related to overall regulatory uncertainty felt by the market over CFTC Dodd-Frank implementation rules, not simply differing margin requirements.
“The CFTC is trying to get the rules right, but also get them to market, to eliminate any regulatory uncertainty. This is a difficult task because if over-prescriptive, they can be inefficient, but if unclear, they can lead to unintended consequences,” he said.
The release of final CFTC rules governing SEF rules has been continuously delayed, most recently with dates in February and March passing with no further clarity.