Dodd-Frank dragged down by latest legal challenge

The Commodity Trading Futures Commission is facing the ire of a major derivatives player because of its margin treatment for swaps, in further evidence of a Dodd-Frank rule making process that is becoming increasingly fraught.

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The Commodity Trading Futures Commission (CFTC) is facing the ire of a major derivatives player because of its margin treatment for swaps, in further evidence of a Dodd-Frank rule making process that is becoming increasingly fraught.

Earlier this week, Bloomberg, a global provider of data, analytics and execution services, threatened the CFTC with legal action over the margin treatment for swaps compared to swaps futures.

Bloomberg is preparing to launch a swap execution facility (SEF), a trading venue that will offer trading in standardised swap instruments, regulated by the CFTC.

Bloomberg’s SEF will be subject to rules in the Dodd-Frank Act, one of the aims of which is to reduce systemic risk in the OTC derivatives market by pushing swaps onto exchange-like venues and clearing houses.

As would-be SEF operators await the final sign off of their rules – expected by the CFTC in the coming months – US futures exchanges have launched swap futures, instruments that replicate a swap-like exposures through a listed future.

Swap futures were initially created so market participants could stay below the threshold of swaps trading that requires them to register as swap dealers or major swap participants under Dodd-Frank. The power and natural gas swap futures listed by IntercontinentalExchange (ICE) quickly sucked liquidity from the OTC markets, while the interest rate swap futures offered by CME Group and Eris Exchange are still gaining traction.

Despite many of the new swaps rules already being in force – including reporting and clearing of credit and interest rate derivatives for swap dealers and major swap participants – this threat of legal action from Bloomberg is not the only one facing the CFTC.

Earlier this month, the Depository Trust and Clearing Corporation threatened to sue the agency after it approved a CME Group rule that requires trades conducted on its market to also be reported to its data repository. The CFTC also had to back down on proposals related to position limits for commodities after coming under fire from several firms on Wall Street.

The crux of Bloomberg’s legal threat to the CFTC relates to the lower initial margin payment required for swap futures compared to swaps, which the firm believes will drive liquidity away from SEFs. Futures typically require margin based on one-day value-at-risk (VaR) calculation, while for swaps margin is based on a five-day VaR, raising the cost for institutional investors that use the instruments for hedging purposes.

“With ICE, CME and others able to offer futures products that have substantially lower margin requirements than swaps that are otherwise functionally interchangeable, the implications for SEFs (which cannot offer futures) are profoundly disturbing,” wrote Eugene Scalia, a partner at law firm Gibson, Dunn and Crutcher, in the letter to the CFTC on behalf of Bloomberg.

Bloomberg wants an equal, one-day VaR margin methodology to apply to cleared swaps and futures and has requested a response to its letter by 19 March, so that it has enough time to receive injunctive relief, if required, before mandatory clearing starts for US financial entities on 10 June.

Margin treatment

In the event that a counterparty to a derivatives trade goes bankrupt, initial margin is used to protect the non-defaulting counterparty from any resulting losses incurred from the defaulting company.

The customisable nature of OTC derivatives means they are considered more risky and require an initial margin that reflects a minimum liquidation period of five days, compared to one-day for listed futures that have standardised contract term.

As such, Sean Owens, director of fixed income and derivatives at financial consultancy Woodbine Associates, believes the CFTC’s margin treatment for swaps vs. swap futures makes “complete sense”, pointing to fundamental differences in the make up of each instrument.

“Futures contracts, like the deliverable IRS contract from the CME, are totally standardised products. Swaps are not and are characterised by different effective dates, rates etc. and are not generic,” said Owens. “Futures are traded on a designated contract market (DCM) via a central limit order book. Swaps have the flexibility to trade on a SEF or DCM and are not restricted to central limit order book trading.”

Owens added the proposed margin framework creates incentives for the trading of more generic futures products and central order book execution, which he viewed as longstanding objectives of Dodd-Frank.  

“The way things stand, we may see a meaningful increase in the use of futures versus swaps, which is positive for the markets as a whole,” added Owens.

Hedging implications

But others believe encouraging a mass migration from swaps to futures could increase systemic risk by limiting the ability of institutional investors to precisely hedge risk.

“The standardised nature of futures makes it more difficult for an investment firm to accurately offset risk when using these instruments compared to a more bespoke OTC swap,” said Ted Leveroni, executive director of derivatives strategy and external relations at post-trade processing firm Omgeo. “Some market participants will move to futures because of the cost, but there are concerns they will not be able to achieve the perfect hedge.”

Leveroni added it is not just the added margin requirements that could lead firms to increase their use of futures. For example, he cites the reluctance of some brokers to serve the buy-side’s needs for cleared swaps trades.

“Buy side firms that are struggling to find brokers to meet their OTC derivatives trading and clearing needs are being pushed to the futures market, where they already have established broking relationships,” he said. “Regulators are clear in their position that swaps contain different risks compared to futures, so it is unlikely that they will go for equal margin treatment.”

While the CFTC may be reluctant to ease initial margin for swaps, some believe the increased collateral demands may be relaxed once the new swaps legislation beds in.

“Margins are not static,” said Holland West, partner at law firm Dechert. “One approach could be to start by using a higher margin for swaps and then ease requirements going forward, as the cleared swaps market grows and develops. However, high margins from day one will only discourage swaps market participation.”