CFTC Shows Anticompetitive Behavior With Swap Margin Rules

Another lawsuit may be headed the CFTC’s way over the implementation of Dodd-Frank rules, and the terror of administrative agencies, Eugene Scalia, may be filing it on behalf of Bloomberg. Mr. Scalia, a partner at Gibson Dunn, prevailed on behalf of ISDA in its suit challenging the CFTC’s imposition of position limit rules. He also beat back an SEC rule-making -- but I am not commenting on that; I’m just pointing out his success with the financial regulators.                    

This time, Scalia is representing Bloomberg L.P., which intends to launch a SEF (an exchange designed for the execution of swaps trades), but is objecting to the CFTC’s rules that would require interest rate swaps to have a margin requirement covering a possible price move over a five-day period.

Interest rate swap futures, and futures in general, do not have any CFTC margin mandate; instead, they have margins set by the exchanges, usually to cover a possible one-day price move. The additional collateral requirements for swaps would clearly cost investors more than maintaining a comparable position in interest rate futures.


Considering all the effort and fuss made by the CFTC and Congress to make sure that swaps are an “open access” market, unlike the vertically integrated trading and clearing operations of the major futures exchanges, this proposal would certainly drive business to the futures exchanges under a “closed access” model and hurt the new entrants to swaps executions that hope to compete.

And, in the case of interest rate swaps, the margin requirements for SEF-traded positions compared to exchange-traded positions does not make sense. Margins are put in place to protect the clearinghouse and its members from the default of another clearing member. Margin requirements are intended as a buffer to protect any clearing member, and thus the clearinghouse that guaranties that clearing member, from having to meet a customer’s loss with its own funds. The thought is that a futures contract can be liquidated immediately should the need arise. Of course, some futures contracts may be too illiquid to provide for quick liquidation of a failed position and should require more than a one-day margin coverage.


Interest rate swaps, on the other hand, are very liquid, and their economic risk can always be hedged with euro-dollar futures contracts should liquidity unexpectedly dry up. The risk, in other words, is less with an interest rate swap than with a thinly traded futures contract, yet the CFTC allows the futures contract to be margined at a far lesser level than the highly liquid swap.


The CFTC has, at best, a small body of direct experience in setting margin requirements, and it has rarely if ever intervened in an exchange’s margin decision. The CFTC’s blanket rule on swaps margins takes away the decision on proper margin levels from the clearinghouses, which really do have the expertise to evaluate risk and determine appropriate margin levels.

Bloomberg is looking to compete in the interest rate swaps space that Dodd-Frank envisioned opening to robust market competition. The CFTC’s one-size-fits-all margin rules for the swaps markets are indeed arbitrary, and show the agency pulling its punches when it comes to seriously laying the foundation to open the largest segment of the over-the-counter derivatives markets to competitive forces.

DTCC vs. CME: A Battle Between Competition and Regulation?

Two financial industry heavyweights -- the CME Group and the Depository Trust & Clearing Corp. -- are in a war over the seemingly mundane topic of derivatives data storage. While the subject matter sounds unremarkable, the fight shows the difficulty the CFTC faces in bringing competition to the swaps markets when a less competitive model from the listed futures world offers a better regulatory tool. The collision between the Dodd-Frank model of “open access” swaps markets and “closed access” futures markets presents a stark choice for regulators: Enhance market competition or regulate the derivatives markets in the best way possible.

Although Title VII of Dodd-Frank specifically directs that the trading and clearing of swaps be done in an “open access,” or fully competitive model, Congress and the CFTC have also chosen time and again to retain a “closed access” model for listed futures, and they have done so with a complete understanding of the limits their choices place on competition. Dodd-Frank did not specifically extend the “open access” provisions to Swaps Data Repository (SDR) services, and it did not condition or limit a “closed access” market participant from using its futures-related assets to build a successful “open access” market to trade or clear swaps. As such, CME is assertively seeking to take advantage of the benefits its traditional marketplace can bring to its success in the swaps markets.

DTCC characterizes that assertiveness as impermissible anticompetitive behavior, in effect imprinting the “closed” practices from the futures world onto the new “open access” market structure for swaps. DTCC, in its letter to the CFTC opposing the CME’s proposed Rule 1001 -- which ties the choice of using CME’s Swaps Data Repository to the decision to use CME’s clearinghouse for a swaps trade -- dramatically describes its position as protecting “the integrity of the Dodd-Frank Wall Street Reform and Consumer Protection Act’s (‘Dodd-Frank Act’) primary objectives.”

The dispute over data storage raises a number of questions about whether non-competitive practices long associated with the futures industry can also become a feature of the OTC derivatives space as well. The answer seems to be yes, as traditional restrictions on anti-competitive business practices meet a complex new market structure. Given a wide-ranging statutory scheme such as Title VII of Dodd-Frank, which is enforced by a fully empowered regulator -- the CFTC -- the regulator will decide competition issues in light of how they impact the regulation of the markets and the safety of the investing public. Competition concerns will not stand on their own in a black-and-white determination of whether a new practice will be allowed in the absence of a statutory mandate.

In the interest rate space, CME will likely clear the large majority of swaps due to the benefits its customers will receive from margining their swaps alongside CME’s pool of listed futures. Language in the proposed rule, which requires approval by the CFTC, gives a customer discretion to ask the CME to forward the same proprietary swap information to another SDR; but the rule is silent about whether a customer that requests its data be moved will incur extra costs in doing so, and thus be deterred from asking.

In the murky waters around competition in the derivatives space, the CFTC faces two questions in deciding on Rule 1001: (1) Can the CFTC better regulate the markets where most data -- at least for interest rate futures and swaps -- is retained by a single entity, in this case the CME? And (2), can CME’s cost structure be designed to protect users of its clearing services from being disadvantaged by using the data sharing arrangement called for by Rule 1001?

Competition among SDRs is subordinated in Dodd-Frank to regulatory interests. In the case of SDR regulation, Dodd-Frank empowers the CFTC to fashion rules as it sees fit to meet its regulatory burden. The statute even empowers the Commission to force any or all SDRs to report their data into a centralized SDR, should that help it better regulate the markets (7 USC §24a(a)(c)(4)(a)). It is almost inconceivable that the Commission would not be better off in fulfilling its regulatory duties with a more concentrated deposit of swaps data than a more dispersed one, especially given the weak customer concerns in maintaining robust competition in data storage.

Unfortunately for DTCC’s position, the anti-competitive issues that it raises are not particularly strong in the SDR context. DTCC’s argument over data storage is a fight between competitors and their allies over issues that have little, if any, bearing on the well-being of customers in the derivatives markets. Derivative customers have no commercial interest in where their data is stored for review by the CFTC, other than how much storage will cost at any particular SDR. In contrast, customers have strong interests in choosing one SEF over another, or one DCO over another, because execution and clearing services are integral components of what makes a trade successful or not.

As to the issue of cost -- which is the only customer interest at stake in this decision -- the CFTC could easily mitigate such concerns in order to obtain a better regulatory result by conditioning Rule 1001 on the CME waiving any fee it charges for SDR services, including transfer of data, to a customer requesting a transfer. (To glimpse the type of power that regulators have in controlling fees to maintain a “fair and orderly” market, consider the SEC’s imposition of a fee cap of 30¢ on exchange fees in securities markets.)

DTCC has direct experience from its recent past in a conflict between competitive concerns and regulatory interests. In the situation in mind, DTCC (through its subsidiary FICC) received SEC approval to partner exclusively with a single exchange to offer collateral reductions for that exchange’s futures contracts when offset by U.S. Treasury Securities held in DTCC’s utility clearing business. The SEC allowed DTCC to move forward because it saw a regulatory benefit, notwithstanding the anticompetitive issues. (ELX, of which I was then CEO, vigorously opposed DTCC’s proposed rules in that venture). Regulatory interests -- even when not compelling -- can overcome competitive concerns where markets are subject to a regulatory agency’s oversight under broad statutory powers, as is the case with swaps regulation. The CFTC, like the SEC,has the same opportunity to evaluate this case on the merits of what is best for the market -- more aggregation of data in fewer SDRs, or more fragmented availability of data in more SDRs.

In its role as the market regulator, the CFTC’s main focus will be on whether Rule 1001 will enhance its ability to act upon trade and position information for the benefit of the public. DTCC’s anti-competitive concerns are indeed substantive, but they will not be evaluated in a vacuum. Rather, they will be decided, and likely disposed of, in light of regulatory interests, the relative lack of customer harm, as well as moving the pace of Dodd-Frank regulation forward in a sensible and effective way.

Originally published in Tabbforum.com, 2/21/13 

http://tabbforum.com/opinions/dtcc-vs-cme-a-battle-between-competition-and-regulation