Friday, October 12, 2012

When Swaps Become Futures

October 12 marks the starting point for many of the new swaps regulations put into effect by the CFTC as part of its implementation of Dodd Frank.  For dealer banks and other large financial companies, the transition of their status from counterparties to registered swaps dealers seems to be going relatively smoothly.  As Dodd Frank was adopted as a means to regulate banks and large, systemically important financial institutions, in the financial world the rules have been long anticipated and broadly tracked.  Moreover, many of the regulations affecting the new categories of Swaps Dealer (SD) or Major Swaps Participant (MSP) are consistent with existing practices within the divisions of financial firms that already deal with the exchange and clearinghouse community.

The energy and commodities businesses, however, have little history in the operations and mechanics of the exchange and clearinghouse space.  Yes, they use the listed futures markets, but have no large trader reporting system or experience in trade reporting to clearinghouses or their related swaps data repositories.  The new SD and MSP rules also affect capital requirements and margin requirements, and create "know your customer" duties that are within the comfort zones of large financial entities, but unfamiliar practices and unwanted business intrusions in the commodity merchant space or among large commodity based companies with significant swap activity.

Starting Monday, October 15, 2012 the Intercontinental Exchange (ICE) will begin to treat all of its energy swaps contracts as futures contracts.  Ten years ago, NYMEX, now a subsidiary of the CME Group, started a service called Clearport in which energy swaps were converted to futures and cleared as futures.  CME has also has announced a plan to start later this year that will list these various swaps contracts as futures.

What is the difference between accepting swaps and converting them to futures, as Clearport has done for a decade, or listing swaps as futures in the first instance as ICE will start doing on Monday?  The answer lies in one of the traditional principles governing trading on futures exchanges (Designated Contracts Markets or DCMs).  Core Principle 9, as it is known in Section 5(d)(9) of the Commodity Exchange Act, requires each DCM to meet a standard of "open and competitive trading" of futures contracts.

In 2010 the CFTC proposed several new regulations that specifically defined the parameters of Core Principle 9 (CFTC Regulations 38.501-06).  Included among these proposals is a proposed centralized market trading requirement to establish a minimum exchange trading threshold of 85 percent for all contracts listed on a DCM. 17CFR§38.506 (see page 80588 in the linked Federal Register).  The punishment for a DCM's failure to satisfy the minimum trading threshold is eventually the loss of listing privileges for that contract on the DCM.  In other words, once a contract is removed from the DCM it is no longer a futures contract and can only be traded as a swap.

If the proposed 85% threshold were to be implemented most, if not all, of the current Clearport contracts would no longer be eligible to be designated as futures contracts.   Importantly to the energy firms dealing with the potential of facing registration as an SD or MSP, each swap contract that is executed from October 12 forward (subject to the CME's request for a short delay) would count toward triggering the registration requirements for SDs and MSPs.  Futures contracts, on the other hand, are not part of the triggering mechanism for SD and MSP designation.  On the commodities side, inasmuch as firms want to avoid designation, one means to do so is to convert swap contracts into futures contracts.

ICE announced that its swap contracts would be redesignated as futures contracts on October 15, 2012.  The CME announced that it would do the same for its Clearport contracts, albeit about 60 days behind the ICE schedule.

However, in order to be successful at this redesignation, ICE has announced a plan to place the swap contracts alongside its traditional futures contracts on its single futures matching engine.  CME will likewise add the swaps to GLOBEX as part of its plan.

The open question will be whether the CFTC will insist on a trading threshold of 85% or something similar which may defeat the plan of converting futures to swaps.  On June 12, 2012 the CFTC announced a "wait and see" period in considering a final rule under Core Principle 9.  Likely, one of the things the regulator will be waiting to see is whether the energy and commodity trading firms that wish to avoid SD and MSP designation will participate in trading some portion of the former swaps on an open and competitive platform.  Alternatively, should these firms not participate on the ICE and CME central limit order books, the CFTC may well see the transformation of swaps to futures as an improper evasion of the swap registration and trading requirements.

The ball at this point is really with the commodities industry that uses the futures and swaps markets.  The two leading commodity DCMs are providing a sound path to help meet the industry's desire to avoid new registration requirements while enhancing the public's interest in seeing derivatives regulated.  Either the major trading firms will change behavior, and execute a meaningful number of swaps on a central platform, or they risk becoming subject to SD and MSP registration.

For the CFTC, if it relaxes a firm 85% or similar prescriptive exchange trading requirement in order to give the markets a chance to transition, the public will receive the truly significant benefit of fully regulated and transparent swap markets alongside futures markets.

Let us hope for a little give and take in the wait and see.

5 comments:

  1. Neal - Spot on -
    As we spoke about what worries me is the CFTC has not had a good handle on the "new electronic markets" and clearing issues .. I do not see how they will catch up with the swaps - if not regulated correctly - the past blow ups will seem small to what will happen in the future , both in size and speed
    David Greenberg
    www.greenbergcapital.com

    Greenberg Capital LLC

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  2. Hi Neal,

    I agree with you on the concept of being eligible for trading on cleared platform and the failure of not meeting the CFTC requirements. However as you mentioned the little knowledge on the governing mechanics of the swaps for operation structure still proves to be a question industry wide, is indeed quite true.

    However I think Conversion of Bilateral Swaps into Centrally Cleared Derivatives is going to be a change in the industry. Operation and Strategy wise the model favors no collateral being held and clearing cash by trading swaps in futures model by realizing daily and netting of trading fees. This definitely reduces counter party risk and by realizing cash daily provides better opportunities for trades and investment mangers to invest smartly based on the market move.

    With up coming EU crisis, I believe the sooner we start conversion the better we save our self from sinking down.

    Being Subject matter expert on Client on Boarding for end to end Dodd frank implementation, conversion and Migration with Centrally cleared swaps, I've noticed the concept is still young and it will take some time to accurately implement the By product of Bilateral + Futures = Centrally cleared derivatives.

    The challenges I've seen, within operations, lie in the area of B.O and Custodian accounting and Realized v/s unrealized model of cash/security movement, as the exposure of fees is netted with daily margin ( cash is moved just like futures where we settle daily margin). This leaves a gap in the accounting part for traded interest which leads to double counting thus require carefulness.

    Further challenges are with the CCP and counter parties to get their trades submitted and cleared electronically. Although the daily pricing is solved by groups like CME on the credits by providing standard pricing for each investment grade product however the challenge still remains on the individual pricing of CCP Vanilla's where in Clearing houses like LCH have two ID reporting for the same Vanilla and leave to the client / counter party to choose what to use for daily pricing whereas CME provides prices based on two accrual methodology and leave up to the client to choose based on the accrual methodology they might follow internally.

    Some challenge also lies in the inbound trade capture either at the clearing house/ counter party/ client / Custodian / back office with different technology version floating around such as FPML / XML / CSV /N-leg, leaving a gap in technology for not having a standard format (say header / attributes) to capture and pass on the data.

    This will require further spending of money on technology enhancement and with each client submitting their own format will posses a problem until standard way of submission is agreed upon.

    Despite of all the challenges or technology enhancement I think its better to spend worth 10 - 20 M on technology update and conversion rather than leaving our selves at the risk of collateral being held.

    Regards,
    Sahil

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    Replies
    1. Sahil,

      You raise many good points and are obviously a student of the efforts to clear derivatives. Having spent most of my career in the futures and securities markets, I like that standards for trade input, collateral, pricing of the instrument, etc. are conventions that are well settled. Thus, I like the fact that at least commodity swaps can take advantage of these established conventions. In the remainder of the bilateral world, there is a desire among large market users to maintain differences between the listed and formerly unlisted derivatives. This will inevitably cause costs to rise, and delay the implementation of a satisfying and workable set of processes. Thank you for your comment, and please feel free to stay in touch.
      Neal

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    2. Sahil,

      You raise many good points and are obviously a student of the efforts to clear derivatives. Having spent most of my career in the futures and securities markets, I like that standards for trade input, collateral, pricing of the instrument, etc. are conventions that are well settled. Thus, I like the fact that at least commodity swaps can take advantage of these established conventions. In the remainder of the bilateral world, there is a desire among large market users to maintain differences between the listed and formerly unlisted derivatives. This will inevitably cause costs to rise, and delay the implementation of a satisfying and workable set of processes. Thank you for your comment, and please feel free to stay in touch.
      Neal

      Delete
  3. Hi Neal,

    I would agree with you here on the fact of identifying the problems with unlisted derivatives and commodity swaps.
    It is good to identify the problem first as then we can work towards the solution of it.

    Thinking of eliminating the differences and bringing the two platforms together is a challenging task with having only few support to the idea to mirror what works, in this case a centrally cleared system for investment banking.

    Here the suggestion I would have is to analyze the current gaps in either migration or conversion so that slowly but surely we build a globally interactive financial system.

    Regards,
    Sahil.

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