On Friday, Oct. 15, a rule designed to improve government oversight of the multitrillion-dollar market for derivatives took effect. The following Monday, many energy traders moved their swaps business to a futures exchange. After the U.S. Commodity Futures Trading Commission put two years into building its regulatory framework for swaps, a slice of the market simply sidestepped it. The CFTC was caught off guard by the move, says Scott O’Malia, one of five commissioners. “All these people left the swaps market due to regulatory uncertainty and confusion,” he says. “That is fundamentally a big problem with the swaps rules.”
As economic officials worldwide have tried to improve regulation after the financial crisis, getting a grip on swaps has been a top priority. And it’s proven to be extra tricky. Broadly speaking, these unregulated contracts are agreements between two parties to exchange payments based on such things as interest rates, currencies, or changes in credit quality. To make things more complicated, either party to a swap is generally free to sell its position. The most notorious of these instruments are credit default swaps, which provide protection against a borrower failing to pay its debts. By creating a huge unseen web of financial obligations, credit default swaps added to the uncertainty that froze credit markets during the financial crisis. They were also responsible for the government’s $182 billion bailout of insurer American International Group, which had sold billions of dollars of them.
The Dodd-Frank regulatory overhaul sought to reduce risk in the swaps market in part by having as many as possible trade on an exchange where prices and volumes are posted, as well as having trades settled by central clearinghouses that guarantee payments. The CFTC began writing new rules after Dodd-Frank passed in 2010. The rule that took effect in October requires that any entity trading more than $8 billion of swaps a year—whether a financial company like a bank or a hedge fund, or a “commercial user” like an airline or a shipping company—be considered a swaps dealer and be subject to government audits and higher capital levels.
That prospect didn’t sit well with many market participants, including those who were buying and selling swaps on an electronic trading platform run by the IntercontinentalExchange. Prompted by its customers, ICE took all the energy swaps that had been trading on its electronic marketplace—more than 900 contracts—and used them to create futures contracts that could trade on its futures exchange. So now, instead of creating a customized swap with another trader, an airline that wanted to lock in the price of 1 million gallons of jet fuel at a certain date would buy jet fuel futures contracts created and managed by ICE.
Many of ICE’s commercial customers requested the change because they didn’t want to be classified as swaps dealers, says Kelly Loeffler, ICE’s vice president of investor relations. “Customers were looking at what was going on with swaps,” she says. “Clearly the regulations were going to be onerous.” ICE’s rival, the CME Group, which operates the Chicago Mercantile Exchange, took similar steps to move its energy swaps business into futures. In December the CME began trading a futures contract designed in part by Goldman Sachs that’s meant to replace interest rate swaps, and ICE says it’s exploring the creation of ones that mimic credit default swaps.
Some companies that rely on swaps for hedging are feeling the impact. Dynegy, a Houston-based utility, uses a variety of energy swaps to hedge fuel and electricity prices. It does most of its deals with large banks that don’t require it to post cash collateral. Chief Executive Officer Robert Flexon says that since the second half of 2012, it’s become harder to do those deals because banks subject to new rules have less appetite for deals. “It’s completely regulatory driven,” he says. As a result, “we can’t hedge maybe as much of the portfolio as we would like or as far out as we would possibly like.”
In a Jan. 14 analysis for Bloomberg Government titled “Futurization of Swaps,” economist Robert Litan argues that large portions of the $379 trillion market for interest rate swaps and the $27 trillion market for credit default swaps may migrate to take advantage of lower collateral requirements. Traders have to post collateral—also called margin—to cover potential losses. For interest rate swaps and credit default swaps, the CFTC now requires traders to post margins equal to five day’s worth of maximum potential trading losses. For comparable futures contracts, the collateral is one to two days of potential losses.
That difference in margin sets up a clear incentive to move swaps trading into futures, says J. Christopher Giancarlo, executive vice president of GFI Group, an interdealer broker that matches trades between large institutions, including swaps transactions. Those institutions stand to lose business if more swaps become futures. Giancarlo says that pushing swaps trading onto futures exchanges hands too much control to ICE and CME, the two biggest. And risks now shared by many institutions will be concentrated at ICE and CME. “You’re potentially creating the next Too Big to Fail,” says Giancarlo. CME and ICE dispute that contention. ICE’s Loeffler says the exchange operates under extensive regulation that “facilitates a reduction in systemic risk.” Bloomberg LP, the parent of Bloomberg Businessweek, operates a trading platform for swaps and along with GFI is part of a coalition called Companies Supporting Competitive Derivatives Markets.
Others are not so alarmed by the futurization of swaps. Darrell Duffie, an economist at Stanford University and an expert on derivatives, wrote a rebuttal to Litan’s Bloomberg Government analysis, arguing that futurization is “natural and appropriate, and should not be viewed as an end run of Dodd-Frank swap regulations.” Energy swaps moved because they were ready to migrate to futures, says Duffie. That is, there were a sufficient number of similar contracts, and enough trading volume, to create a centralized market. On a futures market, swaps will be subject to regulation—after going completely unregulated for years.
Duffie adds that most credit default swaps won’t find their way to futures exchanges because they don’t change hands often enough. “You’re not going to set up a futures exchange to trade a CDS on Dell,” says Duffie. “There’s not enough volume for it.”
Still, the CFTC’s O’Malia is not pleased with how things have gone so far. He says Congress included a stipulation in its mandate to the CFTC on writing rules for swaps: Do no harm to the end-user—the companies that rely on swaps to lock in prices or protect against surprises. By that measure, O’Malia, who has scheduled a roundtable at the CFTC on Jan. 31 to discuss the issue, thinks his agency has come up short. If corporations that rely on swaps find it “more cost-effective and transparent” to move to futures exchanges, he says, “you can’t say you’ve done no harm” to the swaps market. “We’ve tipped their world upside down,” he says. “When that happens, you know you’ve missed the mark.”