Energy Swaps Migrating to Futures on Dodd-Frank RulesMatthew Leising
More than half of the $18 trillion in notional daily trading of energy swaps has moved to futures exchanges from the over-the-counter market in response to the U.S. regulatory overhaul aimed at increasing transparency following the 2008 financial crisis.
Intercontinental Exchange Inc. said 52 percent of its energy futures volumes during the first half of January came from contracts that prior to Oct. 15 were traded as swaps. CME Group Inc. said about 90 percent of energy trades on its ClearPort system are executed as futures, compared with 10 percent before the switch.
Volumes have soared at the two largest U.S. futures exchanges as oil and gas companies seek to avoid higher costs that come from being designated a swaps dealer under the Dodd-Frank Act, which the Commodity Futures Trading Commission said is any firm that does more than $8 billion of the transactions annually. The shift also helps Intercontinental and CME Group to maintain their dominant clearing businesses.
“Dodd-Frank has this phobia of swaps and imposes more onerous requirements on swap dealers,” said Craig Pirrong, director of the Global Energy Management Institute at the University of Houston. In a direct response to the rules, companies are avoiding higher collateral, capital and trading expenses to “get the same trades and risk-management benefit” with futures, he said.
The CFTC, which has been writing the swaps rules for more than two years to improve oversight of a market that for three decades had largely escaped federal regulation, has scheduled a roundtable meeting on so-called futurization for Jan. 31. The agency plans to meet with industry representatives to discuss different collateral requirements between swaps and futures.
Swaps, which allow investors to speculate or hedge price movements in underlying assets such as interest rates, commodity prices or corporate and sovereign creditworthiness, are being regulated for the first time after their role in exacerbating the financial seizure that followed the failure of Lehman Brothers Holdings Inc. in September 2008.
CFTC Chairman Gary Gensler, in an Oct. 10 speech at George Washington University in Washington, likened the efforts to securities rules enacted in the 1930s.
“Bright lights of transparency will shine,” he said. “Dealers will have to come under comprehensive regulation.”
Overseas regulators including the Hong Kong Monetary Authority and the Reserve Bank of Australia have asked the CFTC for more clarity on the international reach of its swaps rules. The agency has since delayed action on this issue and asked for more comment.
In 2011, CME Group reported 11 percent of its clearing and trading fees revenue came from swaps on its ClearPort service, which includes energy. The company earned on average $2.73 per contract on ClearPort, compared with 76 cents for trades executed on the exchange in the three months ended in November, CME Group said in a Jan. 3 statement.
Intercontinental earned 34 percent of its total transaction and clearing revenue from over-the-counter natural gas, power and oil contracts in 2011, according to its annual filing.
The conversion of swaps into futures, which are agreements to buy or sell a financial asset or commodity at a specific price and time, is boosting market transparency, though not necessarily as regulators anticipated.
Energy companies from oil refiners to utilities that once traded swaps now turn to block trades, which are privately negotiated futures deals struck off the exchange that are then entered into the CME Group or Intercontinental clearinghouse. Energy swaps are typically used by businesses such as airlines to lock in jet-fuel prices.
The prices and sizes of these trades that previously cleared as swaps now are reported throughout the day on the website of CME Group. The world’s largest futures exchange didn’t report any information on the trades when they were swaps, said Damon Leavell, a company spokesman.
Intercontinental is now required by law to report all futures trades. Prior to the shift, the second-largest U.S. futures market had displayed cleared swap prices to market users and regulators, unless one or both counterparties requested the trade remain undisclosed.
The clearinghouses, which collect margin at the beginning of a trade, establish mark-to-market prices and ensure investors can cover their losses for the life of the contract, have made it more expensive to process some swaps than futures. Swaps can be more difficult to price in case of an investor default.
The CME Group and Intercontinental clearinghouses require five days’ worth of margin when interest-rate and credit-default swaps are cleared, while for futures, the period ranges from one to two days, depending on the contract.
Interest-rate or credit swaps are less likely to follow the path of energy swaps into futures because it’s harder for banks and other financial firms to stay below the $8 billion threshold, Terrence Duffy, executive chairman of CME Group, said in a Jan. 17 interview in New York.
Even with more business coming to futures because of Dodd-Frank, “the swaps market’s not going away,” Duffy said.
Futures contracts based on the most-actively traded credit swaps indexes are also being developed at Intercontinental.
The company said last year it plans to offer futures in the first quarter based on credit-swap indexes belonging to Markit Group Ltd., the largest creator of the derivative instruments in the $23 trillion market. The gauges will reference London-based Markit’s North American and European corporate credit swap measures.
The market for swaps, in which investors trade payments for as long as 30 years, is measured by notional value to calculate money flows and doesn’t represent cash that has changed hands.
The notional value of interest-rate swaps totaled $379 trillion as of last June, according to the Bank for International Settlements in Basel, Switzerland. The credit swap market stood at $23.5 trillion, according to the Depository Trust & Clearing Corp.
Pirrong said more swaps won’t be turned into futures in the rates and credit swap markets because of the CFTC threshold. Instead, investors are more likely to use futures contracts such as Eurodollars, which track interest-rate movements over three months and settle to the London interbank offered rate, he said.
CME Group began offering interest-rate swap futures in December as another option for derivatives users to trade futures instead of swaps. They’re bought and sold as futures and convert into a cleared rate swap if the contract is delivered.
Congress passed Dodd-Frank in July 2010 to oversee the unregulated over-the-counter derivatives market following the financial crisis and the collapse of Lehman, one of the largest swaps dealers. The millions of swap trades between banks made it difficult for government officials to determine how interconnected the firms had become.
The legislation also addressed several changes in the regulated futures market that the CFTC has overseen since 1974.
Under Dodd-Frank, all swap prices and trades will be required to be reported to data repositories so that regulators can view the market. Most swaps will now be backed by clearinghouses that collect margin and cancel any trade in which investors can’t cover their losses so that risk doesn’t build in the financial system. All trades that are cleared must be executed on exchanges or similar electronic systems.
JPMorgan Chase & Co., Goldman Sachs Group Inc. and Barclays Plc were among the first banks to register swap-dealer divisions under Dodd-Frank this month. In all, 65 trading units signed on, including the biggest banks in the U.S., U.K., France, Germany, Switzerland and Japan, according to the CFTC.
Intercontinental’s energy swaps market totaled $9.3 trillion in notional value in 2011, according to its annual report. CME Group has a similar share of the business, according to a person with knowledge of the matter who asked not to be identified because the information isn’t public.
About 97 percent of the former energy swaps at Intercontinental are now traded as futures, while at CME Group they’ve transitioned 88 percent, according to the companies.
The change to futures from swaps resulted in an additional 1.36 million daily energy trades on average at Intercontinental from Jan. 2-15, according to data from the company’s website. That amounted to 52 percent of the average 2.6 million trades across all its energy products over the same period.
Bloomberg LP, the parent of Bloomberg News, is part of a coalition called Companies Supporting Competitive Derivatives Markets, consisting of companies with swap-trading systems that raised concerns futurization will result in fewer protections for customers and less stringent margin rules. Other members include GFI Group Inc., Thomson Reuters Corp., ICAP Plc and Tradeweb Markets LLC.
Dodd-Frank encouraged competition in the swaps market by allowing contracts to be executed and cleared at different companies. For example, a swap bought on Tradeweb could be cleared at LCH.Clearnet Group Ltd., CME Group or Intercontinental.
In contrast, futures trading and clearing can only be done at the same company, allowing Intercontinental and CME Group to wall off their energy clearing from rivals.
Pushing swaps trading onto futures exchanges hands too much control to Intercontinental and CME, Christopher Giancarlo, executive vice president of GFI Group, told Bloomberg Businessweek.
Interdealer brokers such as GFI “have not lost any significant amount of business” from futurization, Giancarlo said.
The CFTC granted CME Group an extension to Dec. 31 for the $8 billion level for swaps dealer to begin because the company wasn’t ready for the change as of October.
CME Group and Intercontinental said they expect revenues from clearing the block futures trades to remain the same as when they were swaps as the fees are largely the same.
Given the level of complexity of the new rules, including the $8 billion threshold, the migration to the futures market reflects a “natural progression,” CFTC Commissioner Scott O’Malia said in a telephone interview.
“They were leaving behind a regulatory nightmare that is the swap dealer definition,” said O’Malia, who said he doesn’t oppose the trend. “How you compute up to the $8 billion de minimis swap dealer level is anyone’s guess.”