The Core Principle 9 Debate

Core Principle 9 governs the requirement for CFTC regulated futures and options transactions to be executed in an open and competitive fashion.  Requiring futures and listed options to meet the open and competitive standards makes perfect sense: the purpose of a futures market is to allow for price discovery and hedging of market risk to occur. 

CP 9 is intended to assure that prices determined on regulated exchanges fairly and accurately represent the value of the underlying commodity or financial interest.  If a market is competitive – open to many different interested users all looking to have the market reflect their personal opinion of value – and open, so that all of these interested competitors can see at all times what price his competitor believes is true value, then the market will function effectively as a mirror of value.  

Placing a numeric threshold on whether the market is competitive threatens to move such important products as Crude Oil (LO), Gasoline (OB), and Heating Oil (OH) Options and Nasdaq 100 (ND), Palladium (PA), and S&P 500 (SP) futures off of regulated exchanges.   Natural Gas (ON) and Gold (OG) Options as well as Gasoline (RB) and $10 Dow Jones (II) Futures have between 10% and 15% of their volume executed off-exchange, and are threatened with removal.

The first issue is what is the public benefit of removal?  To place such products alongside a medley of swaps that have no real bearing on the price discovery function of markets seems to lessen the price discovery function of these important products. 

Once a product is labeled a swap, or ineligible for trading on a Designated Contract Market (DCM), it is not formally subject to the full “open and competitive” requirements of DCM Core Principle 9.  However, by proposing large block trading sizes, and mandating electronic execution and immediate reporting of trades, the rules for swaps are moving fairly close to the CP9  standards, a kind of CP9 "lite" approach. 

It appears to me that products that have traditionally traded as futures contracts likely serve an important price discovery function, and ought to be left on highly regulated DCMs.  Products that are typically unimportant to price discovery (swaps) do not require CP9 lite or any other prescriptive trading regime. 

Is there a benefit to treating important products for price discovery as swaps, and treating swaps as important products for price discovery?  I don’t think so.  The trading rules for swaps are moving closer to the standard for CP9 without a good reason to impose a standard meant for instruments that have a pricing function in the economy.  The fact that a highly complex swaps trading regime, is in the works does not make it an appropriate venue for futures contracts that are economically important to pricing of key goods and services. 

Having essentially taken the Pink Floyd approach to futures regulation:  “…Regulator, leave those futures  contracts alone…” I also believe that applying open and competitive trading requirements to swaps - CP9 “lite” - also makes little sense to me.

The vast majority of swap transactions have little or no impact on the price of the underlying good or service.  Oil swaps derive their value from the price of oil futures; same with natural gas; same with interest rate swaps relying on U.S. Treasury cash and futures prices as well as the Eurodollar futures market; agricultural swaps depend on the price of benchmark agricultural futures; metals swaps rely on cash and futures gold and silver futures markets.  These are derivatives that have little independent  impact on the price that the public cares about such as gasoline at the pump or home mortgage rates.  If 85% of the swap trades occur openly in the public square rather than over a phone, the public good will not be improved even marginally. 

The traditional function of futures exchanges has worked well, and continues to do so.  DCMs should be granted broad discretion to determine which products affect price discovery, and to offer them discretion to meet the open and competitive standard of CP9 as has always been the case.

Swaps, on the other hand, do not need a futures-like trading regime.   The problem with swap trading is not the lack of price transparency, which is important in pricing core goods.  Rather, swaps have lacked risk transparency.  Knowing how many have been issued, who holds them, and how are they  valued and collateralized are issues of broad public importance.   Uncleared swap transactions, as opposed to swaps executed according to one set of rules or by private means, actually pose a threat to the public interest.   How they were executed does not have much significance in protecting the public, however. 

Threatening to displace important products from DCMs is unsettling to the market.  Creating a CP9-like set of trading requirements for swap markets does not lessen the threat to the public’s ability to get price discovery benefits from these products.  Indeed, focusing at all on the pricing mechanism for swaps that do not impact the price discovery process is time better spent on applying trade reporting and clearing to the swaps world.