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Futurisation of Swaps and the Regulators

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According to Aditya (2013), futurization is the transition of swaps onto the futures exchange from the OTC swaps market. The new chapter of futurized swaps and other Over the counter derivatives is facing some of the issues i. e. , collateral reductions, risk mitigation and multilateral position netting across various pools of counterparties (Kaminski,2013). The new swaps future are new variants of swap contracts which are meant to replicate the existing features of swaps. To link, “futures are related to forwards as swap futures are to swaps” (Kaminski, 2013).

The new swaps futures contract is a hybrid product which seeks to contain personalized features of swaps while transacting on a centralized exchange to give relief to existing OTC swaps traders. (Aditya, 2013). Delivery options and block trading would become convenient on futures exchange. Modifications and exceptions will ultimately make new swaps (future swaps) fit somewhere in the gray zone (uncertainty) in the middle of traditional futures and traditional swaps contracts (Kaminski, 2013).

Swap futures are an attempt to trade swaps, but do so under the regulation of the futures market as futures contract have inherit benefits. The conversions of cleared OTC swaps into futures, as well as the advent of swap futures, mimic a swap under a futures wrapper (Aditiya,2013) Futurization of swaps may come across as being a relatively recent development, however, a lot has been done in the past to try and regulate the existing OTC Derivatives market. Congress passed The Dodd-Frank Act in America and the European Market Infrastructure Regulation (EMIR) were introduced in 2008.

This was the year; the world saw one of its greatest financial meltdowns – The Great Financial Crisis of 2008. One of the reasons credited to the crisis was the unregulated swaps market and its high rate of default. The swap market, was mainly an OTC-oriented market that aided trade and construction of highly personalized contracts that varied on a number of terms and conditions. In 1974, the Commodity Futures Trading Commission (CFTC) was set up to regulate the futures market in order to regulate swap dealers of America by improving transparency and introducing clearing houses in the equation of a swap Trade.

However, their authority over the OTC derivatives market was never well outlined and consequently there were many problems faced by the unregulated OTC market as stated by. Halm-Addo (2010) sheds some light on the same and cites this confusion to be the main reason for the CFTC to have faced a number of lawsuits. Given how extremely personalized an OTC swap is, the market was extremely difficult to regulate due to the degree of variability of the assets traded. Crucially, this made the OTC derivatives market, prior to 2008-09, decentralized and difficult to administer effectively.

Dodd-Frank and EMIR aimed at regulation and convergence of trading of listed and OTC derivatives on one unified exchange. This was crucial to improve transparency and exercise greater control over the swap Market. Also, it aimed to reduce the risk associated with default on behalf of counterparties by introducing the role of clearing houses in the process. The main issue associated with Dodd-Frank is that it possesses limited capacity to eliminate the risk factor. Interestingly, it transfers the risk to another participant of the transaction – the clearing houses.

By involving clearing houses, the liability of a default lies with the clearing house. This, in contrast, implies that clearing houses deal with risk management for liquidity purposes whereas they were built to deal with risk of default by counterparties. Phillip Stafford (FT, 2015) raises another cause for concern on how there are only a handful of institutions that are authorized to clear swap agreements. By concentrating this responsibility, in one major market, the regulation could possibly create a monopoly. Also, in the situation wherein a Clearing House runs into trouble, how will they be bailed out?

Importantly, can the new regulated system, potentially be concentrating and amplifying the risk component which may eventually affect the market? As an answer to this criticism, there are many central institutions in America and Europe that are developing and improving institutional framework of the Derivatives market as well as the Clearing Houses, in the case of such a crisis. Imeson (Wolterskluwerfs, 2017) sheds some light on how the new Recovery and Resolution Regulation proposal for Clearing houses, issued by the European Commission in 2017, can help bail out such institutions if met with a crisis.

Aditya (2013) advocates that futurization of swap would reduce regulatory burden as swaps have high cost of registration and a high compliance cost to ultimate users in the form of higher monetary fees, however use of swap futures allows market participants to cut back the nominal volume of their swaps, protecting Swap dealers or Major swap participants from the burdensome registration procedures with the CFTC. “Regulatory arbitrage encourages market participants to pick more advantageous regulatory schemes for cost saving, accounting, tax, or other purposes.

The comparative clarity of regulatory schemes now favour futures”. (Taylor ,2013). As per the report of CME group (2013) The stringent capital requirements under Basel III have changed the requirements of capital and associated cost for financial institutions. The degree of customization offered by the product has direct relationship with the transaction costs. As the margin accounts of futures require less collateral, it becomes more attractive for investors as compared to swaps. The initial and variation margin requirement in futures is less as compared to swaps i. e. n swap, margin requirement includes a 5-day value at risk charge (VAR), while in futures margin requirement is 1 day VAR charge.

Highly Customised swaps require additional margin in excess of five-day VAR subject to CVA Var under Basel III. Thus, the higher margin requirement of swaps makes the total activity of trading swaps inefficient. Swaps future require different block trade requirement i. e. a block trade is a swap of large principal value. Usually these block trade are exempted from SEF trading requirement, it stated that these transactions can happen over the phone as they have been traditional.

These trades should be reported, and the clearing mandate will still apply, but reporting of these will be delayed as there is no requirement of pre-trade price transparency on the screen. The CFTC has proposed setting relatively high minimum block requirement for swap trade on a swap execution facility. On the hand, each DCM set its own minimum requirement for future contracts, which led to minimum block requirement which are inconsistent, but they are much smaller in general as compared to the CFTC required block for swaps. (Aditya, 2013).

In the current scenario of derivatives market, swaps futures provide greater certainty to investors as compared to swaps as futures exchange are already well established and fully functioning, whereas new rules governing swaps execution, clearing and reporting post Dodd Frank act remain unsettled and complicated, resulting in reduced regulatory uncertainty surrounding the futures, which are cleared and exchange traded. (Aditya, 2013). As the Dodd-Frank Act makes the use of swaps data repository (SDR) compulsory for centralised swap data reporting and recordkeeping.

Futures are vertically aligned reporting as compared to the swaps market which are horizontal aligned reporting i. e. in swaps they have a SDR (Swaps Data Repositories) it is that in which the swap data reporting and recordkeeping is done. Also, vertically aligned reporting restricts the competition for exchanges. All swaps whether they are cleared or uncleaned are required to be reported to registered SDRs. (Aditya, 2013) It is obvious that the transition from swaps trading onto futures exchanges would give excessive control to ICE and CME (Philips, 2013).

According to a study conducted by Aditya (2013), there is high exposure to basis risk in the futures contract as the contracts are standardized, creating an imperfect hedging strategy due to imperfect correlation between hedge and the price of the underlying asset. Further to aggravate the problem, no futures contract might exist to match the desired duration of a hedge. Entities may fail to comply with the hedge accounting rules under Financial Accounting Standard 133 because futures contract incorporate increased basis risk due to inexact hedge (Ryan, 2012).

Whereas bilateral swaps are known to be highly customised contracts which firms utilise according to their specific hedging requirements, thus basis risk exposure is mitigated. Interestingly as mentioned by Taylor (2013), hedging customised risks is the preference of most of the swap counterparties, which are not easily traded on futures exchange due to inherent trading constraints on futures platform. As a result, the number of homogenous futures contracts to hedge an exclusive position is generally greater than the number of swaps transactions required, this leads to higher operational costs of using futures contract.

As per an article in Euromoney (2013) a major US chemical producer had mentioned once that they hedge their exposure by executing about 150 trades in the OTC swaps market whereas in the futures market it would take about 144000 futures contracts to hedge the same exposure. Rosenberg and Massari (2013) have investigated and clearly stated that the current regime for collateral in futures market requires massive improvement as non-defaulting customers of a Futures Commission Merchant (FCM) may incur heavy losses in cases of default by a FCM’s customer and subsequent inability of FCM to guarantee that payment with its own funds (double default).

This may cause a financial contagion. Whereas the new swaps model post Dodd-Frank Act improves the segregation of customer collateral into separate customer accounts, protecting non-defaulting customers from “fellow customer risk” in the event of failure of FCM (Taylor, 2013). Another key issue is that transparency becomes less as swaps move to futures exchanges as “swaps transactions are reported in real-time, but there’s a 10-minute delay in futures price reporting”. (Litan, 2013). This directly impacts the ability of investors to make informed decisions.

Also, swaps prices are transmitted to public data repositories, where investor or anyone else can get them for free. In contrast, data repositories are not compulsory in case of futures as futures exchanges have a claim over the prices they report and levy fees for their release (Litan, 2013). The process of futurization, via Dodd-Frank and EMIR, does contradict the true nature of swaps. The Acts that have been brought into force to regulate the swap market have encountered increased resistance from participants within and outside the system.

In principle, a swap essentially provides a personalized hedging contract at a reduced cost. John Carney (CNBC, 2013) supports this opinion by saying that if all the three main points of the Act are adhered to, there will not be any virtual difference between a swap and a future. Through adherence to the requirements of the regulations, the low cost of swaps is immediately affected and is further, incapacitated. In future, when we progress towards centralization of any nature, it becomes increasingly difficult to provide a high level of personalization and the market progresses towards more standardized contracts.

Crucially, difficulty arises in creating regulations for every possible detail in a swap Contract. The problem of centralizing all transactions by introducing clearing houses in a swap transaction may even create a situation of collapse in the derivatives market. This may be a result of increased dependency of the market on just a small number of clearing houses. Also futurization is not feasible for all types of swaps for instance credit default swaps cannot be transacted on futures exchange.

However, there are many steps that are being taken to counter the criticisms of the Dodd-Frank Act mentioned above by many central institutions in America and Europe. These proposals for new regulations aim to modify and rectify the problems that were posed by the existing Acts. A regulation is successful when it has done its job to provide its participants with a transparent and secure market to hedge their exposure. As far as the regulations adhere to that, the swap markets can move successfully towards futurization.

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