Swap Dealers Go to Washington, Demand a Level Playing Field

Tensions flared this week as derivatives dealers and other intermediaries met to debate the final rules for swaps alongside regulators and their counterparts on the futures side.

A hot topic was the move toward swap futures listed on exchanges, and that raised concerns that the playing field is no longer level.

Swap dealers worry that lighter margin requirements in futures and block trading thresholds could influence which platforms — swap execution facilities or exchanges (also called Designated Contact Markets) will attract the most liquidity.

They are also frustrated because after two years of rulemaking the SEF rules are not yet finalized and their business plans are in limbo. One of the effects of the delay with SEFs, there are moves by exchanges to turn swaps into futures, said Adam Sussman, partner and director of research for TabbGroup, at the firm’s "Fixed Income 2013: Liquidty, Products, Platforms" conference.

[For more on OTC Derivatives Reforms and Mandatory Electronic Exchange, see Sapient Global Market's related story.]

Dodd Frank allows for swaps to be traded on electronic exchanges or regulated electronic platforms if they are centrally cleared, but there is still uncertainty as to which execution methods can be used for block trades.

While the more liquid types of swap indexes like CDX and iTraxx can be traded electronically, one speaker on the panel said, “When it comes to single names, swaptions, that’s a more complicated market. They need to get it right.”

But Wall Street investments didn't get much sympathy from CFTC Chairman Gary Gensler at a public roundtable on Thursday, according to a Reuters article.

"Approximately eight-ninths of the derivatives market place (is) swaps and until recently was unregulated. Now we bring regulation to both sides, is it not just natural there might be some realignment?" said Gensler.

Gensler, who is charged with carrying out rules that are compliant with Dodd-Frank, wants to bring more transparency into the $650 trillion swaps market, and has looked to the futures model. However, participants on the swaps side who have invested time and money in building swap execution platforms are upset that some of the key rules on margin requirements and block trading thresholds could tip the volumes toward the futures industry. Specifically if the margin amounts are lower on the futures side, it could be cheaper to trade swaps on an exchange.

Futures and options have a one-day margin requirement or enough collateral to withstand market swings for one day, according to Reuters. For cleared swaps, the margin requirement is five times as high and for uncleared swaps, it is 10 days, making these instruments far more costly to trade.

Already, several futures exchanges have launched so-called swap futures – sparking the trend toward what’s known as “futurization of swaps.”

In October, the InterContinental Exchange (ICE) moved its energy swap products to become futures, “to avoid the increased regulatory burden,” noted Reuters. CME has launched swaps-like futures contracts while newer entrants like Eris Exchange, a CFTC regulated exchange, known as a Designated Contract Market (DCM), which offers interest-rate swaps futures contracts. TrueEx is also a DCM but describes itself as a Dodd-Frank compliant swaps exchange, which will initially serve the $300 trillion global interest rate swaps (IRS) market. It is currently testing and on-boarding clients and plans to go live in the first quarter of 2013.

Ironically, swap dealers are saying that if the CFTC were to impose tougher rules on swaps, users will flock to futures, with their lower margin and collateral requirements, which would actually make the financial system less safe.

“If swap and swap futures are economically equivalent then they should have the same margin,” said an executive with one of the major trading system providers that plans to register as a SEF, on the TabbForum panel.

Others see the futures potentially gaining traction because of the regulatory uncertainty with swaps. “There’s certainty in the futures rules,” said one buy-side head of global trading at the TabbForum panel. “That’s why swap futures are interesting to me,” said the trader.

However, the buy side trader is also watching the SEFs for they will potentially offer multiple market models for trading complex, customized swaps. “The last thing I want to do is speculate on who the winners will be,” said the buy-side trader.

Sell side firms and others want to see competitive market structure evolve. When Tabb’s Sussman asked if there was a desire for an all-to-all market or RFQ (request for quote) model, an executive with a wholesale broker said, “ I’d like to see all of those tools.” Anticipating that there will be several platforms, investment banks plan to become aggregators as well. “The ability to provide a screen which aggregates all the different regulated venues…will be a service to clients,” said a sell-side derivatives executive at the Tabb conference.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio