Exchange consolidations: Help or hospice?

Over the ensuing years, the swap market grew rapidly. It is estimated today that the notional value of swaps now exceeds that of regulated futures contracts by some multiple, although precise comparisons are challenging. It appears that swaps hold appeal in the commercial world over futures for a variety of reasons, arranged here in ascending order of importance based upon the author’s many discussions with swap market participants:

  • Privacy. Exchange trading is highly visible. Orders are generally open to public view. And the details of completed transactions (except identities) are commonly disseminated on a real-time basis. But swaps can be negotiated and executed on a bilateral basis and there has not been (until recently) any need to disclose what has occurred. The less competitors know. . . .
  • Disruption. Related to privacy, many swaps are of such magnitude that offering them into the public market could destabilize prices there, at least momentarily. No such effect is risked with private transactions.
  • Counterparty Risk. Trading on the regulated futures markets opens the transaction to all takers. While the risk of counterparty default is small due to the guarantee provided by the exchange’s clearing house, the ability to winnow potential counterparties in advance for their creditworthiness is seen as a valuable precaution of private negotiation.
  • Collateral. While regulated exchanges and their clearing organizations follow a strict policy of margining all transactions, requiring initial deposits of funds and later additions if market changes are adverse, what (if any) collateral is needed for a swap is left to the good judgment of the immediate parties. Many commercial firms believe that they free up substantial capital by using swaps that can be employed for other purposes.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, massively amending the Commodity Exchange Act, undertook to draw swaps closer to the bosom of the CFTC through the imposition of numerous new requirements similar to those endured for years by the regulated futures exchanges. In particular, it was billed as legislation that would require many, if not most, swaps to be executed on competitive trading venues, either pre-existing “designated contract markets” (where futures occur) or new “swap execution facilities.” It was also said to force more such swaps onto clearinghouses where obligations are guaranteed by funds aggregated by its principal users. While those goals may yet be attained, several features of the Dodd-Frank Act suggest that the outcome could be quite different.

Definition of “Swap.” The revised Act defines the term “swap” very broadly, and calls on the CFTC to provide additional content. In particular, the statutory definition captures many of the commodity options that CFTC had regulated under pre-existing authority. In addition, the CFTC has signaled that it may allow to be classified as “swaps” certain instruments that—identical to futures—require or allow the physical delivery of the underlying asset. If so, no discernible difference would any longer exist between futures and swaps, offering the specter of swaps absorbing futures as the prevailing trading system for derivatives and, potentially, letting traders choose their preferred regulatory regime simply by what they elect to call their instruments.

Exemptions. The Dodd-Frank Act offers a generous number of exemptions for swaps only from the on-exchange/clearing requirement, not least for swaps used by commercial firms to hedge or manage their business risks. The CFTC has also signaled that it may allow commercial hedgers substantial leeway in making their own collateral arrangements. The author estimates that this waiver will affect many if not most swaps. As a result, private dealings may be only moderately affected by these reforms.

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