Derivatives-trading rules are facing scrutiny at the U.S. Commodity Futures Trading Commission after the country’s largest exchanges began replacing energy swaps with futures last year.
The five-member commission held a roundtable meeting in Washington yesterday with representatives of exchanges and trading firms including CME Group Inc., Intercontinental Exchange Inc. and Deutsche Bank AG. The agency is reviewing if the new futures contracts have enough transparency and competition or if too many transactions are being allowed off exchange by setting low levels for so-called block trades.
“I think it’s a natural thing for some realignment to take place,” CFTC Chairman Gary Gensler said at the meeting. “It is also critical that we preserve the pre-trade transparency that has been at the core of the futures market.”
Scott O’Malia, a Republican commissioner, and Bart Chilton, a Democrat commissioner, have said the agency must watch changes to the thresholds for block trades.
“The transition to futures in the energy market has been facilitated by the exchanges establishing extremely low threshold sizes for block trades in the futures contracts,” O’Malia said in a speech Jan. 30 at a TabbForum conference in New York. “This is a significant issue that needs to be sufficiently thought through by both the commission and market participants.”
As part of the 2010 Dodd-Frank Act, the commission has sought to increase the ability to see bids and offers for derivatives before they are traded to improve transparency, competition and liquidity in markets. The switch in energy trades, and the potential for a similar conversion in interest-rate and credit derivatives, has prompted the agency to consider if its rules are strong enough.
Futures are agreements to buy or sell an asset or commodity at a specific price and time. They have standard sizes and maturities, are traded on exchanges and guaranteed at clearinghouses that take collateral from buyers and sellers. Swaps are traditionally traded directly between buyers and sellers, sometimes with customized maturities and sizes, and often aren’t guaranteed at clearinghouses.
The CFTC, which has regulated futures contracts since its creation in 1974, won authority under the act to oversee swaps, which had been largely unregulated since their development in the early 1980s.
As the new CFTC rules took shape, ICE and CME in October began moving swap contracts to the futures market. During the first half of January, ICE said, 52 percent of its energy futures volumes came from contracts that prior to Oct. 15 were traded as swaps. CME said about 90 percent of energy trades on its ClearPort system are executed as futures, compared with 10 percent before the switch.
Firms setting up swap execution facilities that would compete with CME and ICE have raised concerns about the futures conversions, saying they could move beyond energy swaps and increase risk to the financial system by requiring inadequate collateral. CME has introduced a so-called swap future contract tied to interest rates, while ICE announced a plan to tie futures to indexes of credit defaults.
A group, Companies Supporting Competitive Derivatives Markets, told a House Financial Services Committee hearing in December that the shift to futures was a consequence of the CFTC’s regulations. The agency should re-examine its rules because conversions could reduce transparency and competition in swaps, the group said in its testimony.
The coalition included interdealer brokers and companies with trading platforms, such as GFI Group Inc., Icap Plc, Thomson Reuters Corp. and Bloomberg LP, the parent of Bloomberg News.
The CFTC should revise rules governing collateral for swaps guaranteed at clearinghouses, George Harrington, global head of fixed income trading at Bloomberg LP, told the CFTC in a Feb. 1 letter. Final CFTC rules require five-day margin for financial swaps, while financial futures typically require one or two days depending on the contract.
The CFTC should adopt an order requiring clearinghouses impose the same margin requirements for financial swaps as financial futures, Harrington said. “We believe that the disparity in the margin rule on its face will be the strongest driver of the forced ’futurization’ of economically equivalent financial swaps,” he said in the letter.
Terrence Duffy, executive chairman of CME, said in written testimony to the congressional committee that the exchanges are focused on promoting choices for their customers. Critics of the futures conversion are speaking out of self-interest rather than concern for all risks in the market, Duffy said.