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Bloomberg Joins Leaders in Submitting Testimony on Swap Rules

December 12, 2012

NEW YORK — Today Bloomberg LP, GFI Group, ICAP, Parity Energy,
Thomson Reuters, Tradeweb and Tradition submitted written
testimony to a U.S. House of Representatives Financial Services
subcommittee on derivatives legislation. The following is a copy
of the testimony.

Chairman Garrett, Ranking Member Waters, thank you for the
opportunity to submit written testimony on the economic and
market implications of Title VII of the Dodd-Frank Wall Street
Reform and Consumer Protection Act (Dodd-Frank). The companies
[1] supporting competitive derivatives markets are composed of
individual market participants who support the intention of
Congress to bring transparency to and reduce systemic risk in
the futures, options, and swaps markets.

Responding to public outrage fueled by the financial crisis in
2008, world leaders convened for a G-20 meeting in Pittsburgh in
September 2009, and agreed that the $700 Trillion global over-
the-counter swap markets must be regulated, not eliminated. In
July 2010, Congress passed and the President signed Dodd-Frank
into law to do just that. While some lobbied for the end of the
swaps market in favor of futures products, Congress concluded
that it was important to preserve the $300 trillion U.S. swaps
market which had grown organically for almost 30 years. Congress
carefully drafted each provision of Title VII of Dodd-Frank and
directed the Commodity Futures Trading Commission (CFTC) and the
Securities Exchange Commission (SEC) to implement it with two
specific goals in mind: reduce systemic risk in the U.S. swaps
market through measured regulation and preserve the role of
swaps in the U.S. economy. We vigorously support and respect
those goals.

Congress intended to reduce systemic risk in the swaps markets
by increasing transparency. To that end, Title VII explicitly
requires swap transactions to be reported to data repositories,
it requires certain swaps to be traded on regulated platforms to
promote the goal of pre-trade price transparency, it requires
post-trade reporting of swap transactions to the public in real-
time, and it contemplates that swaps should be able to be traded
on regulated platforms and cleared at any clearinghouse willing
to accept them. While the specific implementation of these
policies was left to the CFTC and SEC, Congress went to great
lengths to set forth a regulatory structure designed to reduce
risk, increase transparency, and preserve the character of the
U.S. swaps markets. Congress understood that regulating the U.S.
swaps markets would be among the most significant market
structure undertakings since 1934.

So where are we now? After nearly 2 ½ years of rulemaking, the
CFTC’s cumulative approach to swaps regulation has imposed such
high costs on the industry that the U.S. swaps market is on the
verge of becoming too costly and too regulated (particularly as
compared with futures) to be a viable means for end user to
hedge and manage their financing risk. The overwhelming
differences between swaps and futures rules on determining block
trade sizes, real-time reporting, registration, cross-border
trades, business conduct, and potentially, most important, the
cost of margin and capital is threatening to strangle the U.S.
swaps market in favor of the futures market through the
technicality of a “swap future”.

It appears that by simply changing the name of the product from
a swap to a swap future, market participants can avoid swap
regulation entirely. In its attempt to regulate the swaps market
in a different manner than the futures market with respect to
economically equivalent financial instruments, the CFTC created
regulatory arbitrage between the only two products under its
jurisdiction: swaps and futures. By creating an unequal playing
field between economically equivalent swaps and futures, the
CFTC’s swap regime may find itself directly at odds with
Congress’ intent to preserve the U.S. swaps market.

Does it serve the public interest when the federal government,
through a regulatory framework, effectively creates a mandate
that swaps be converted into swaps futures? Does it bring
additional transparency or the reduction of systemic risk to the
broader derivatives markets? On close examination, we believe
the answer is “no”.

First, does the conversion of swaps to swap futures enhance
competition? The answer is no. Swap futures are not subject to
the same trading fungibility and open access clearing
requirements that Congress requires of swaps; thus, the vertical
monopoly of the futures industry is further entrenched and
competition from swap execution facilities (SEFs) and new
derivatives clearing organizations is greatly reduced.
Importantly, by removing choice of product and venue farmers,
corporates, pension funds, insurance companies, and consumers
will be subject to increasingly higher costs for execution and
clearing. Competition has been further impacted by the delay in
the SEF rules as compared with the rules for exchanges. In the
absence of a SEF framework and infrastructure, the marketplace
is moving away from that uncertainty toward the existing
exchange and swap future paradigm – effectively giving the
vertical silos an even more entrenched monopoly.

Second, does the conversion lead to greater transparency? The
answer is no. Swap transactions are required to be reported to a
data repository that regulators can access to conduct market
surveillance and systemic risk oversight. Swap futures contracts
are not. Swap transactions are statutorily subject to real-time
post trade reporting on a publicly accessible data repository
website. Swap futures contracts are not. These differences
ensure that, unlike the swaps markets, only those entities or
individuals with the resources to afford real-time data for swap
futures contracts will have access to it. In addition,
commercially operated exchanges control the size of block trades
for futures contracts, unlike swaps where the block size is set
by the CFTC and SEC. The inevitable result will be differing
minimum block sizes between swap futures and swaps, with futures
exchanges looking to gain commercial advantage. Certain market
participants will look to arbitrage the differing block sizes to
conduct transactions off-exchange or off-SEF depending on where
they can access greater trading opacity outside the broader
liquidity pool. As a result, whether a derivative instrument is
called a swap or a swap future and not its underlying risk
profile will determine its price transparency. In short, the
CFTC’s rules, with respect to economically equivalent
instruments, favor the futures markets over the swaps markets,
and the CFTC (or Congress) must address these differences. As
currently constructed, these rules undermine the benefits to the
public that Congress intended for Title VII.

Third, does this conversion protect those Congress intended to
protect? All of the transparent business conduct protections
that the consumer advocate groups fought so hard to include in
Title VII to protect pension funds, schools, and municipalities
(Special Entities) from the risks of swap transactions can be
legally evaded using an interest rate swap future. There is no
obligation for a Special Entity to engage a fiduciary-like
advisor to act on its behalf to detail the risks or costs
associated with the use of an interest rate swap future. There
is no obligation to disclose conflicts of interest when
marketing an interest rate swap future to a Special Entity.
Again, by simply changing the name of the product, the taxpayer,
retiree, and ordinary citizen are left completely unprotected
from some of the risks that Title VII was designed to prevent.
As the Consumer Federation of America and the Americans for
Financial Reform rightly noted in a comment letter to the CFTC,
“with the adoption of the business conduct provisions of the
act, Congress clearly intended not just to provide greater
transparency, though that is important, but also to transform
the nature of the relationships, particularly with regard to
special entities.” We would suggest that the differences between
swaps and swap futures have made certain that will not happen.

Fourth, has the conversion reduced systemic risk in the broader
derivatives markets? We would argue that it has not. Swap
futures are imperfect hedges and they will cause market
participants to self-insure the basis risk that the swap future
does not hedge. This outcome promotes a buildup of the same type
of opaque unregulated balance sheet risk that plagued numerous
entities during the 2008 crisis, and it will be dispersed
throughout the system. Additionally, because futures contracts
expire and market participants are forced to “roll” the expiring
contract on the expiration date into a new contract to maintain
the hedge, they are now exposed to market risk and the
possibility that high frequency traders will time the roll and
cause the price of the contract to increase. This will lead to
more volatile credit markets, which can exacerbate systemic risk
and negative feedback loops in times of market uncertainty and

We would also highlight that the unequal margin requirements
that the CFTC set forth for economically equivalent swaps and
futures will lead to an increase in concentrated risk. A
financial swap requires a 5-day margin and a financial swap
future requires a 1-day margin. Why? If the risk to the U.S.
financial system is the same, then why are economically
equivalent products treated differently. By requiring
clearinghouses to hold lower margin for a swap future with the
exact same risk as its economically equivalent swap, the CFTC is
not reducing risk in the system; its policies are actually
forcing the clearinghouse to absorb more risk. In a liquidity
crunch or a downgrade of its clearing members, a clearinghouse
will require more, not less collateral, to protect itself from
cascading defaults, and this problem is exacerbated if the
required margin held at the clearinghouse was inadequate to
begin with. Margining the swap future at one day could aggravate
risk to clearinghouses, market participants, and the U.S.
financial system during the exact time when the system can least
afford it: episodes of market uncertainty and crisis.

Fifth, does the conversion benefit Main Street consumers? The
answer again is no. The Main Street consumer’s insurance
company, or the firefighter’s, policeman’s and teacher’s pension
fund, or the farmer, or the corporation that is the single
employer in a town that previously used swaps are all worse off.
They have lost access to pre-trade price transparency, they have
a ten (10) minute delay on post-trade price transparency unless
they pay hundreds of thousands of dollars to obtain access to it
in real-time, they have imperfect hedges that expose them to
market volatility, price volatility, and high frequency trading
strategies, they are forced to pay increasingly higher costs to
trade and clear their derivative contracts because there is
limited price competition, and they could be forced to bailout a
clearinghouse in a crisis because the margin levels are

Sixth, how does the conversion impact the jurisdiction of this
Committee? Subtitle A of Title VII clearly sets out that the
CFTC regulates swaps, futures, and options and Subtitle B of
Title VII states that the SEC will regulate security-based
swaps, which include equity swaps, single name credit default
swaps, and narrow-based indexes composed of less than 10
entities. Swap futures are futures, and therefore, they are
regulated by the CFTC, not the SEC. If almost all of the
security-based swaps that this Committee worked so diligently to
make certain were under the purview of the SEC are converted to
swap futures, which is highly likely given the economics of the
contracts, it is possible that this Committee could lose a large
amount of its jurisdiction over the swaps market going forward.
We find that outcome problematic and squarely against the
Congressional intent expressed in Subtitle B of Title VII.

We cannot overstate the impact this conversion is having on the
U.S. swaps market, and this is not a hypothetical concern. To
illustrate this point, one has to look no further than the
energy swap market in the U.S., where almost all of the
transaction volume has left the OTC swap market and is now being
executed through various energy swap futures contracts. The
market’s move from energy swaps to energy swap futures was a
direct response to the CFTC’s swap regulations. We are elevating
our concerns to your Committee because this market
transformation is taking place without public comment or a
regulatory impact study that analyzes how the conversion will
affect systemic risk, transparency, competitiveness, market
participant choice, consumer protections and the other important
public policy issues Congress sought to address in Title VII.
As a result, we fear that Dodd-Frank’s goals of reducing
systemic risk through transparency and preserving the U.S. swaps
market are becoming increasingly more difficult to achieve.

We urge Congress to think about the following questions as it
continues to carry out its important Constitutional oversight
authority: (1) is the swap future good for the stability of the
U.S. financial system?; (2) should Congress require the CFTC to
revisit each rule that created the unequal playing field between
swaps and swap futures?; and (3) should Congress revisit Title
VII to level the playing field by (A) imposing the same
statutory requirements on futures contracts as it has on swaps?,
and/or (B) mandating that swap futures be regulated as swaps?.
At the very least, we would ask Congress to mandate that (1)
regulators require any new product proposals by exchanges that
convert swaps, as regulated by Title VII of Dodd Frank, into
swap futures to be subject to the transparency of the public
comment process before further products impacting this
conversation are permitted to proceed, and (2) the Government
Accountability Office (GAO) be directed to immediately conduct
an impact study that analyzes how the conversion from swaps to
swap futures will affect systemic risk, transparency,
competitiveness, market participant choice, consumer
protections, and the other important public policy issues
Congress sought to address in Title VII.

We thank the Committee for the opportunity to present our

[1] The individual companies who support competitive derivatives
markets include the following market participants: GFI Group
Inc., ICAP, Tradition, Parity Energy, Inc., Tradeweb Markets
LLC, Thomson Reuters Corporation, and Bloomberg, L.P.

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