Swap-to-Future Conversion Has Regulators Studying Rules

The U.S. Commodity Futures Trading Commission is reviewing whether energy futures contracts that are replacing swaps on the largest exchanges have enough transparency before they are traded, Chairman Gary Gensler said.

The commission has scheduled a roundtable meeting with industry representatives for Jan. 31 to consider whether changes in oversight are needed after CME Group Inc. and Intercontinental Exchange Inc. began converting energy swaps to futures, a move that helps oil and gas traders avoid the stiffest Dodd-Frank rules for swap dealers.

The CFTC, which has regulated futures contracts since 1974, won authority under the 2010 Dodd-Frank Act to oversee swaps, which had been largely unregulated since they developed in the early 1980s. Under a Dodd-Frank rule that took effect in October, energy and other firms that annually deal in more than $8 billion in swaps fall under the most costly capital, collateral and business conduct requirements for dealers.

“Futures and swaps are both derivatives and with Congress’s movement, they’re now both to be fully overseen,” Gensler said in a telephone interview. The CFTC is looking at whether new futures contracts are being traded transparently and competitively, he said.

Areas where the CFTC could make changes include tightening the rules for deciding when a futures contract can be traded outside the central exchanges.

Clearing Swaps

As part of Dodd-Frank, Gensler 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.

Half of traders responding to a survey said they are likely to move some of their business to futures from swaps compared with 18 percent in a similar survey in 2011, Alex Kramm, a New York-based UBS AG analyst, said in a note today. The survey results suggest that between 20 percent and 25 percent of the business done in the swaps market has potential to shift to trades in the futures market, Kramm wrote.

Still, asset managers, banks, hedge funds and insurers included in the survey had concerns about the ability to substitute swaps with futures.

Customized Strategies

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.

Credit swap contracts helped fuel the 2008 credit crisis that followed the failure of Lehman Brothers Holdings Inc. and led to the U.S. rescue of insurer American International Group Inc. and prompted lawmakers to write new rules for the market. The law seeks to have most swaps guaranteed at clearinghouses and traded on exchanges or on alternative platforms known as swap-execution facilities, or SEFs.

The market for energy swaps, which include contracts for commodities including oil, natural gas and jet fuel, has grown for years, allowing traders to get around the regulatory supervision of futures and customize their strategies.

Moving Contracts

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.

“What it does is highlight that once you light the swaps market with trading and clearing, there is no substantial difference between swaps and futures,” John Parsons, professor at the Massachusetts Institute of Technology, said in a telephone interview.

The conversion in certain markets because of new regulations may not be problematic, according to Mark Carney, the head of the Financial Stability Board.

“Futurization is not necessarily a bad thing” if it is consistent with the FSB changes, Carney said today in Zurich. “That said, we are not trying to futurize everything. We leave it to the market to adjust.”

The FSB is a global financial policy group comprised of regulators and central bankers.

Switch Encouraged

The switch may be encouraged because clearinghouses require less collateral backing futures tied to interest rates and credit contracts than for related swaps. The CME and ICE clearinghouses require five days’ worth of margin for interest-rate and credit-default swaps, while for futures, the period ranges from one to two days.

Firms setting up SEFs 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 lobbying 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.

‘High Costs’

“After nearly 2 1/2 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 users to hedge and manage their financing risk,” said the group.

The coalition includes interdealer brokers and companies with trading platforms, including GFI Group Inc., Icap Plc, Thomson Reuters Corp. and Bloomberg LP, the parent of Bloomberg News.

The conversion to futures “was unprecedented in that a vital U.S. market changed its entire trading activity largely to avoid pending regulatory structure rather than for significant commercial or economic advantage or public good,” J. Christopher Giancarlo, GFI Group’s executive vice president, told Congress on behalf of the Wholesale Market Brokers Association, Americas.

Promoting Choices

Terrence Duffy, executive chairman of CME, said in written testimony 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 the overall risks in the market, Duffy said.

“Each trading arena carries its own regulatory burdens,” Duffy said. “It is a disservice to those customers for a participant in one of those markets to promote its private interests at the expense of customers who are quite capable of making a choice that best fits their needs.”

When the CFTC convenes its roundtable discussion on so-called futurization, one area of focus will be block trades, which are transactions deemed large enough to be carried out without having to make their size and price public right away.

While the agency under Dodd-Frank authority will set the block size for swaps, it is the exchanges that now largely set the threshold for futures. If the exchanges lower the futures threshold, more contracts would be excluded from public view.

“The futures market has worked very well,” Gensler said. “We wouldn’t want to see something diminished. We wouldn’t want to see pre-trade transparency undercut or diminished by some approach to futures that would lower block sizes.”

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