More than half of the $18 trillion in notional daily trading of energy swaps has moved to futures exchanges from the over-the-counter market in response to the U.S. regulatory overhaul aimed at increasing transparency following the 2008 financial crisis.
Intercontinental Exchange Inc. said 52 percent of its energy futures volumes during the first half of January came from contracts that prior to Oct. 15 were traded as swaps. CME Group Inc. said about 90 percent of energy trades on its ClearPort system are executed as futures, compared with 10 percent before the switch.
Volumes have soared at the two largest U.S. futures exchanges as oil and gas companies seek to avoid higher costs that come from being designated a swaps dealer under the Dodd- Frank Act, which the Commodity Futures Trading Commission said is any firm that does more than $8 billion of the transactions annually. The shift also helps Intercontinental and CME Group to maintain their dominant clearing businesses.
“Dodd-Frank has this phobia of swaps and imposes more onerous requirements on swap dealers,” said Craig Pirrong, director of the Global Energy Management Institute at the University of Houston. In a direct response to the rules, companies are avoiding higher collateral, capital and trading expenses to “get the same trades and risk-management benefit” with futures, he said.
The CFTC, which has been writing the swaps rules for more than two years to improve oversight of a market that for three decades had largely escaped federal regulation, has scheduled a roundtable meeting on so-called futurization for Jan. 31. The agency plans to meet with industry representatives to discuss different collateral requirements between swaps and futures.
Swaps, which allow investors to speculate or hedge price movements in underlying assets such as interest rates, commodity prices or corporate and sovereign creditworthiness, are being regulated for the first time after their role in exacerbating the financial seizure that followed the failure of Lehman Brothers Holdings Inc. in September 2008.
CFTC Chairman Gary Gensler, in an Oct. 10 speech at George Washington University in Washington, likened the efforts to securities rules enacted in the 1930s.
“Bright lights of transparency will shine,” he said. “Dealers will have to come under comprehensive regulation.”
Overseas regulators including the Hong Kong Monetary Authority and the Reserve Bank of Australia have asked the CFTC for more clarity on the international reach of its swaps rules. The agency has since delayed action on this issue and asked for more comment.
In 2011, CME Group reported 11 percent of its clearing and trading fees revenue came from swaps on its ClearPort service, which includes energy. The company earned on average $2.73 per contract on ClearPort, compared with 76 cents for trades executed on the exchange in the three months ended in November, CME Group said in a Jan. 3 statement.
Intercontinental earned 34 percent of its total transaction and clearing revenue from over-the-counter natural gas, power and oil contracts in 2011, according to its annual filing.
The conversion of swaps into futures, which are agreements to buy or sell a financial asset or commodity at a specific price and time, is boosting market transparency, though not necessarily as regulators anticipated.
Energy companies from oil refiners to utilities that once traded swaps now turn to block trades, which are privately negotiated futures deals struck off the exchange that are then entered into the CME Group or Intercontinental clearinghouse. Energy swaps are typically used by businesses such as airlines to lock in jet-fuel prices.
The prices and sizes of these trades that previously cleared as swaps now are reported throughout the day on the website of CME Group. The world’s largest futures exchange didn’t report any information on the trades when they were swaps, said Damon Leavell, a company spokesman.
Intercontinental is now required by law to report all futures trades. Prior to the shift, the second-largest U.S. futures market had displayed cleared swap prices to market users and regulators, unless one or both counterparties requested the trade remain undisclosed.
The clearinghouses, which collect margin at the beginning of a trade, establish mark-to-market prices and ensure investors can cover their losses for the life of the contract, have made it more expensive to process some swaps than futures. Swaps can be more difficult to price in case of an investor default.
The CME Group and Intercontinental clearinghouses require five days’ worth of margin when interest-rate and credit-default swaps are cleared, while for futures, the period ranges from one to two days, depending on the contract.
Interest-rate or credit swaps are less likely to follow the path of energy swaps into futures because it’s harder for banks and other financial firms to stay below the $8 billion threshold, Terrence Duffy, executive chairman of CME Group, said in a Jan. 17 interview in New York.
Even with more business coming to futures because of Dodd- Frank, “the swaps market’s not going away,” Duffy said.
Futures contracts based on the most-actively traded credit swaps indexes are also being developed at Intercontinental.
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