A Swap By Any Other Name
ICE has created something of a kerfuffle by its announcement that it will convert its cleared energy swaps contracts to futures. Despite a lot of breathless reporting, there is less here than meets the eye.
ICE has merely relabeled its cleared energy swaps as futures in order to avoid burdening its customers with the costs that Frankendodd imposes on swaps. Futures and swaps are subject to different regulatory regimes. Firms with sufficiently large swap positions are considered swap dealers under Frankendodd, and must meet a variety of requirements that those not blessed with this designation can avoid: holders of equivalent futures positions need not meet the same requirements. Swaps trades also involve additional reporting obligations not imposed on futures trades.
So what ICE will do effective in January is change the name of its contracts, thereby reducing the regulatory burden on its customers, without changing their economic substance one iota. Note that these are cleared swaps, so the change doesn’t create a new clearing obligation on those trading them. The central counterparty for the futures will be the same as for the swaps: ICE Clear Europe. The contracts will have identical settlement terms. They will have identical cash flows. They will trade on the exact same ICE platform. The economic substance of every aspect of the old “swap” transaction and the new “futures” transaction remains the same, from execution to clearing to settlement. Nothing changes but the name.
And the regulatory burden.
Which points out the potential for absurd outcomes under Frankendodd. The CFTC has labored mightily to craft definitions of a swap and swap dealers and major swap market participants. Where one falls under these definitions matters a lot. Firms will endeavor to take measures that minimize the regulatory burden they face. ICE is basically picking the low hanging fruit, and taking note of Congress’s morbid obsession with “OTC swaps” and idealization of futures by magically transforming the former into the latter, and thereby making life easier-and cheaper-for its clients.
The incentive to label or structure transactions to achieve the same economic outcome at lower regulatory cost will be quite strong in the Frankendodd era. This will initiate a regulatory dialectic in which regulators will attempt to adjust regulations in order to limit such attempts to escape regulatory burdens by relabeling or restructuring; the regulated will adjust to the adjustments; the regulators will adjust some more; and on and on.*
The lawyers will rejoice.
Much of the reporting on the ICE move has been pretty far off base, such as this from the WSJ:
Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.
ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.
Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations.
ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more-opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets.
. . . .
Many energy producers and users generally have preferred swaps contracts because each contract can be written up individually and to a company’s own specifications. That has enabled them to be more targeted in their hedging. Futures contracts, by contrast, are generally standard contracts covering the price of a specific energy grade to be delivered at a certain time.
Pretty much none of that is true. All of it suggests a change in the way these instruments are designed, traded, and cleared, none of which is in fact changing. The contracts are already standardized, traded on an electronic platform, and cleared. This is not a movement of bespoke, uncleared, bilateral contracts onto an exchange.
Look. It’s long been known that the economic substance of swaps and futures are effectively identical, especially when the former are cleared. Changing the label-hell, call them bananas-doesn’t change the economics. If the CFTC had even less burdensome regulations for bananas, ICE would launch ICE Bananas.
Which illustrates that Frankendodd is quite often and in many ways truly bananas.
* Relabeling of derivatives contracts was employed in the 19th century to avoid legal restrictions. When Illinois banned options trading, traders bought and sold the same things, but started calling them privileges.
[…] – A swap by any other name. […]
Pingback by FT Alphaville » Further reading — August 3, 2012 @ 1:35 am
First an Homage to Milton, and now I hope one to Alfred Kahn by using banana.
Comment by Sotos — August 3, 2012 @ 8:10 am
Good catch, Sotos-that’s exactly what I was thinking.
[…] is calling its swaps ‘futures’ to get around regulation. This sort of thing always tickles the abstract mathematician in me; […]
Pingback by Links « Rhymes With Cars & Girls — August 3, 2012 @ 2:47 pm
I think it is a good beginning. Now, us, the mortals, will also have access to data. 🙂
Comment by MJ — August 3, 2012 @ 9:19 pm
Actually a lot of CDS clearing and OI data is available if you go spelunking in the DTCC web sites – these show net exposures and clearing data but, trust me, most of the players do not know how to read them. One high salesman stated that the data looks like nothing he sees on his desk: well it wouldn’t since it is NET of all the inter-dealer nonsense and does not include the “private label” deals often done to net hedge basis. Proof that you don’t need a deep understanding to make a lot of money – in some areas the thickness of one coat of lacquer will do.
Comment by sotos — August 4, 2012 @ 5:32 am
[…] it a swap, or a […]
Pingback by Breakfast Links | Points and Figures — August 4, 2012 @ 6:26 am
SWP, can you comment on derivative exchanges in the BRIC countries and how they could capture liquidity driven out of the US by FrakenDodd. A larger global exchange seems like a better nexus for liquidity anyway.
Comment by scott — August 5, 2012 @ 3:51 pm
@Scott-I don’t think any BRIC countries are serious competitors for a variety of reasons, including infrastructure but most notably legal institutions conducive to trading and well-developed banking systems that are integrated with global banks.
Singapore is a potential rival. It has had derivatives trading for some time, including a longstanding relationship with CME. It has a strong legal system that is trusted around the world. It is a major trading center. It is in an Asian time zone, and has business hours that overlap China and Japan as well as Australiasia. Most importantly, its government has made a concerted effort to develop Singapore as a financial center.
Look for it to make its play first in commodities, notably energy (in which it is already a major center for the physical trade) and iron ore.
In fact, according to some of the data(http://www.sgx.com/wps/wcm/connect/sgx_en/home/higlights/news_releases/sgx%20derivatives%20and%20clearing%20volumes%20grow)derivatives trading volume has grown in Singapore. I suspect that it is at the expanse of the US and EU markets.
At least one of the regulators of BRIC, the one that soem suggested could promote regulatory arbitrage, has refrained from playing that role, and it appears that it has chosen to replicate the US and EU regulations.
Comment by MJ — August 5, 2012 @ 10:11 pm