MF Global submitted a comment letter to the Commodity Futures Trading Commission (CFTC) Thursday on its rule proposal regarding requirements for Derivatives Clearing Organizations (DCOs), Designated Contract Markets (DCMs) and Swap Execution Facilities (SEFs) regarding mitigation of conflicts of interest as part of the Dodd-Frank Act.
It was not so much a comment on any specific rule proposal but a reminder of the underlying principles of inclusion and competition and an attempt to hold the Commission’s feet to the fire regarding those principles. The letter states that the law requires DCOs to permit fair and open access and points out that two U.S. clearing organizations — presumably ICE Trust and CME Clearing — have already set onerous capital requirements excluding most brokers except the largest bank dealers who have long controlled the OTC swaps market.
“What we are focused on is the broader mandate of Dodd-Frank and that you just can’t abdicate that to the exchanges,” says MF Global executive vice president and General Counsel Laurie Ferber. “Our focus is to make sure that the Commission have real teeth in defining what fair and open access is and that the exchange proposed rules are scrutinized by the CFTC not just a self-certification.”
At issue mainly is the CME Groups structure for its OTC Interest Rate Swaps clearing solution that requires clearing members to have $1 billion in adjusted net capital.
Ferber and MF Global supported the idea of having a separate structure and guarantee fund for swaps, which the CME adopted, but does not see the need for the capital requirement. “Nobody has shown me anything about these markets that says you ought to think about them differently. Look at what the volatility is, look at what margin you have to post, you may want a [higher] cushion but again nobody approached the discussion saying here is what we need here is how I justify it; instead it has been this reverse engineering to justify a really huge number that makes an exclusionary club,” Ferber says.
In a recent interview with Futures, CME Group managing director for OTC products and services Laurent Paulhac defended CME’s solution for clearing OTC interest rate swaps. “We spent a lot of time discussing this with a lot of market participants to ensure the proper safety and soundness of our offering, said Paulhac. “The net capital requirement is related to the strength of the balance sheet of the clearing member. That is very important to us because ultimately what introduces systemic risk in our clearing solution is the potential failure/bankruptcy of a clearing member; the stronger the clearing member, the safer the model.”
Paulhac added, “$1 billion is the right level because of the risk and liquidity factors related to that instrument. Interest rate swaps, even though they are a very large market, are a market that has instruments up to 50 years out so they will stay on some books for that long.”
What is disturbing to Ferber and many other non-dealer Future Commission Merchants (FCMs) is that the rules appear to support the status quo where a handful of bank dealers control the entire interest rate swap market.
“Right now execution is still on a bilateral basis so if your clearing member is one of the banks that has usually been your swap counterparty they are going to want you to execute with them. That is not going to create the broader marketplace that is going to reduce cost to clients. More clearing members [mean] more choice of where you execute, more choice for more clients to participate in this market,” Ferber adds.
And she points out that while MF wants to participate in the cleared OTC space this is really driven by client demand. “We have vast numbers of clients who want to participate in the market who do not clear with one of the major banks, don’t particularly want to, feel in part that they compete with those banks so they don’t want their clearing and execution there and yet they don’t have good choices to participate in that market today.”
And even with OTC swaps moving to clearinghouses, today there is not much different in how they trade. “If I do a bilateral swap I have to take it off with the same person I put it on with, talk about being hostage to the bid/offer spread. If I were one of those banks I would be trying to make sure this opened up as slowly as possible and I keep [making] money trading with my clients,” Ferber says, but adds there is a great demand from buy side customers to participate outside the current structure. “We have lots of hedge fund clients, other institutional clients, classic buy side people who are prepared to participate in these markets but they are not prepared to be [held] hostage like that and they also don’t happen to clear with one of those 12 banks and don’t want to establish their clearing relationships there, they want to be able to clear with the same people they clear their futures with.”
She is hoping the CFTC can bring the transparency that Dodd-Frank was supposed to bring and it will broaden participation.