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.