CME Derivatives That Skirt Dodd-Frank Attracting Review by CFTC

CME Group Inc.’s decision to allow users of its interest-rate swap future contracts to avoid tougher oversight is drawing scrutiny from its U.S. regulator, the Commodity Futures Trading Commission.

The contracts, which begin as futures and are converted to swaps guaranteed by CME’s clearinghouse if held until delivery, won’t be included in totals determining whether users face higher collateral, capital and trading requirements, said Laurie Bischel, a CME spokeswoman. Under CFTC rules, traders who buy or sell more than $8 billion of swaps annually will face the tougher standards by being designated a dealer or so-called major-swaps participant.

“CFTC is currently reviewing this product, and we have not yet taken a view on whether the resulting swap counts toward a market participant’s status as a dealer or major-swap participant,” Steve Adamske, a CFTC spokesman, said in an e-mailed statement. “Market participants are urged to consult the rules in order to determine whether certain products would be in compliance with CFTC swap regulations.”

Executives, traders and regulators are grappling over whether the shift in some swaps to futures contracts, known as futurization, constitutes a grab for market share by exchange owners such as CME Group or is a natural progression in the market as rules mandated by the 2010 Dodd-Frank Act take effect.

The majority of the $18 trillion energy-swaps market traded on CME Group and Intercontinental Exchange Inc. shifted to futures in October in part so users could avoid the higher regulatory costs associated with being a dealer or major-swaps participant.

Self Regulation

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 privately between buyers and sellers, sometimes with customized maturities and sizes, and often aren’t guaranteed at clearinghouses. Interest-rate swaps create a series of payments between investors over the life of the contract that are determined by how rates rise or fall.

CME, the world’s largest futures market, has the authority to approve new contracts it offers without regulatory blessing under its status as a self-regulatory organization, which is granted by CFTC rules. The company used that authority for the contracts, Bischel said.

“As futures contracts, deliverable swap futures don’t count against the $8 billion threshold,” Bischel said in an e-mailed statement. “Even if the futures contract goes to delivery, delivery doesn’t count against the swaps dealing threshold.”

Goldman Revenue

Darrell Duffie, a finance professor at Stanford University, said the CME contracts should count toward identifying large users if they convert to swaps upon delivery. While the shift to futures from swaps is a normal progression, “if the delivery-does-not-count rule is not changed, I would add this to the negative column on futurization,” Duffie said.

The settlement mechanism embedded in the futures contract physically delivers an interest-rate swap if held to expiration. It was designed and patented by an executive at Goldman Sachs Group Inc., according to two people familiar with the matter who asked not to be named because the details are private.

Goldman receives 12.5 percent of all revenue generated from the CME Group contract because of the patent by managing director Oliver Frankel, one the people said.

Michael Shore, a CME Group spokesman, and Michael DuVally of Goldman Sachs, declined to comment.

Underlying Assets

Futures can be used to acquire the physical assets they are based upon, such as gold, Treasury bills, or barrels of oil. While few futures contracts are held until the delivery date, the possibility of delivery effectively ties the underlying commodity to the derivative, which is used to set wholesale prices.

The CME Group interest-rate swap futures trade in increments of $100,000 and are based on two-, five-, 10- and 30-year swaps. Total volume has exceeded $6 billion since they began trading in December, with more than $1 billion of active contracts, according to CME Group’s Shore.

The first contracts expire next month, at which point investors could take delivery of the cleared swaps.