Swaps Futurization: Issues, Debate, and So Many Open Questions

By Larry Tabb

Originally published on Tabb Forum 

There are many questions surrounding swaps futures. The answers will dictate the winners and losers, not only of the swaps market, but of the macro global economy, and they could determine the nature and severity of the next financial crisis. 

I just participated in an online panel discussion about swaps futurization on HuffPost Live. While the logistics of a live, multi-person video were pretty cool, a 30-minute video chat with five participants is not enough time to get across all of the critical issues. That said, I will leverage the FORUM to put across my points that, unfortunately, I was unable to articulately enunciate.

In the zeal to overhaul swaps regulation, the CFTC has been very aggressive in layering on reporting, clearing, trading and oversight mandates for the swaps market. This abundance of regulation (both passed and proposed) has enabled the two major futures exchanges (CME and ICE) to create swaps futures products. These swaps futures products have a number of very real advantages for their users:

1. Reduced regulatory burden 

No need to register as major swaps participants or swaps dealers.

2. Reduced initial margin 

Futures margin is calculated on a one-day VaR versus a five-day VaR for swaps.

3. Greater margin efficiency 

The margin for swaps futures and traditional futures can be offset.

4. Less technology and operational expense 

Most firms already have the ability to trade and process futures.

In addition, there are advantages for designated contract markets (DCMs) in keeping these products in the futures world and out of the world of Dodd-Frank regulation:

1. Greater certainty 

Futures rules already exist and are stable.

2. Vertically aligned trading and clearing 

Futures clearing and trading have traditionally been tightly integrated.

Dodd-Frank mandates clearing choice -- vertically aligned exchanges make it harder for other exchanges to compete.

3. Vertically aligned reporting 

Dodd-Frank mandated choice of SDR (swaps data repository).

Futures exchanges don’t have an SDR mandate (futures have real-time reporting requirements).

4. Futures exchanges have greater control over block size 

This impacts what trades need to occur on the exchange vs. at the dealer (FCM).

Futures or Swaps: Which Is Better? 

The OTC swaps market is big. The outstanding agreements add up to approximately US$600 trillion in notional value, which is 40 times the size of the US GDP. The market turnover is approximately 2.5 times a year, which means that there is approximately US$1,800 trillion of notional value traded annually.

As this market transitions to a more fully cleared, electronically traded market, the worry is multifold:

By centrally clearing all of this volume, and margining it with greater efficiency and at a lower rate than Dodd-Frank mandates for traditional swaps, will there be enough collateral in case something goes wrong? Will the clearinghouse be able to sell the positions without dipping into the clearing fund and possibly causing a financial contagion?

Since traditional futures have historically been standardized, swap futures margin has been pegged to be lower than standardized swaps; customized swap margin is planned to be significantly higher than standardized swap margin. The question is: Will the cost of customized swaps become so expensive that the customized market evaporates?

If so, does the loss of this market convert a market with significant real-world alignment (corporations hedging customized risks) into a trading market for hedge funds and speculators?

If the market successfully transitions to a futures model, will the dealers retain a significant role in the market, or will they be relegated to a much more limited (and less profitable) role, such as an agency broker/FCM?

If the market is allowed to migrate toward a vertically aligned exchange/clearing model, will other competitors (exchanges and or clearinghouses) be shut out?

If the market migrates to futures, where data repositories are not mandated, will there be enough swaps transparency?

Will exchanges set block levels so high that the value of being a dealer is minimized?

These questions and issues are not only very complex and inter-related, but the answers will dictate the winners and losers, not only of the swaps market, but in reality, of the macro global economy. The answers will not hand a trophy to JP Morgan or the CME; but they could determine the nature and severity of the next financial crisis. 

It all comes down to capital. If we have enough capital backing up our risks, then each trader supports his own failed positions. If, however, we don’t collect enough margin on these contracts, then the collective market needs to bail out the failed player. And as we have seen in other contagions, as one player goes, it can take down others, with the end state being a failed clearinghouse, a market in disarray and a global mess. 

Now, I don’t know if one-day or five-day VaR is the right risk measure, or if even if five-day VaR-based initial margin is enough. That said, given the size of the OTC swaps markets, we need to get this right. Getting it wrong would be bad. Very bad.

The problem is, ascertaining the right answers are difficult.

Shouldn’t the clearinghouse know the answer to the margin question? While that may seem a likely place to look, these are new agreements without any history and little liquidity, so there is little data to make an adequate decision. Swaps futures clearing and trading is vertically aligned, and exchanges are public companies, so there is an incentive for the exchanges to underestimate the risk.

On the other hand, if the exchanges win, the dealers’ profitability will be blunted. Dealers clearly have a vested interest, as well.

Ask investors? Don’t they want choice, low cost and a functioning market? This answer could tip either way; however, compared to where investors are now (no clearing mandate), either direction will be more expensive. Picking a winner between swaps and swap futures will only be a matter of degrees. Swap futures should be cheaper, but they will also offer less flexibility – so this may be a push.

End users hedge risks. Risk for corporations is bespoke and not standardized. While governments have made painstaking efforts to exempt end users from the brunt of regulation, additional margin, extra dealer regulation, and a standardizing of the swaps world will cause dealers to raise the price of insuring customized risks. End users will absolutely wind up getting the short end of the stick, as they will be hit with greater costs and less choice.

To recap: The questions are difficult, the costs are high, and the risks are higher; and everyone has a vested interest, except for the end users, who will ultimately pay the price in how they manage their risk. That is, unless we make the wrong decision and things go awry and the taxpayer picks up the bill.

Unfortunately, we have been there and done that. That said, we will probably be there again, but hopefully not because of this dilemma -- that is, if we can get good data, make the correct assumptions, and make the right decisions now, instead of waiting for the next disaster and fixing it through the rear-view mirror.