A New Era in Swaps Markets?*

US CFTC Chairman Gary Gensler declared last month that a new era for the swaps marketplace would start on 12 October 2012, the effective date of the new US swap definition rule. This marked the beginning of the process of swap dealer registration and swap data reporting. Mandatory clearing by swap dealers and major swap participants is expected to follow in February. The new rules are intended to bring transparency to the swaps markets and lower their risks. While the 12 October date may indeed be remembered as a milestone, a close look at the new rules suggests that lingering difficulties remain and that the process of regulatory swaps market reform may still be undergoing teething pains.

Those difficulties should not come as a surprise. There is an inherent tension between, on the one hand, the political clarity of the perceived need for, and urgency of, financial‐market transparency and regulatory reform and, on the other hand, the very complexity of those market’s financial instruments, and hence the great difficulty of regulatory adjustments. When G20 leaders set the broad reform agenda to be implemented by the end of 2012 to reduce systemic risk and increase transparency in the OTC derivatives markets, they might not have fully appreciated the complex nature of the instruments they were dealing with. They might also have held exaggerated hopes that new rules could easily achieve consistency across nations and win consensual international support. Instead, regulators in different countries followed their own paths in designing the rules that were supposed to govern global swaps markets, without engaging into much‐needed cooperation among themselves.

As indicated in the latest FSB progress report on OTC market reforms, it now appears that regulatory differences among regions, including in the cross‐border application of rules, will likely delay the full and timely implementation of the G20 requirements for OTC markets regulations. The FSB urged regulators for more international coordination to provide clarity on how the rules will apply to transactions and entities for more consistent and effective oversight in OTC markets.

Although the US CFTC is still working on the final guidance on the cross‐border application of Dodd‐Frank swaps market reform, interpretive guidance issued in June was heavily criticised by European and Asian regulators as well as other market participants when they met in Washington, DC on 7 November 2012. They have raised their concerns about the unintended consequences of cross‐border application of swaps rules, including potential market disruption or fragmentation resulting in increased systemic risks and reduced market liquidity.

Clearing requirements for standardised swaps through an intermediary company with sufficient capital, such as clearing houses or central counterparties (CCPs), a measure introduced to eliminate counterparty risk, have also become a target of criticism. Proponents of the requirement argue that central clearing has worked in the futures markets for over a century. Critics counter that the present regulatory reform and regulations may not remove the systemic risk from OTC derivatives but rather shift it from counterparties to central clearing parties. A recent IMF paper concluded that the current proposed central clearing system, far from reducing systemic risk, actually increases it.

Some observers argue that the CFTC has rushed to meet arbitrary deadlines without providing proper analysis of the costs and benefits of the new rules for swaps markets. The CFTC’s last minute issuance of a series of no‐action and interpretive letters and other guidance just before the 12 October deadline was interpreted as proof that the Commission had failed to develop clear and cost‐effective rules, as noted by one of its Commissioners.

Market participants are already searching for ways to escape from costly and complex regulations of the swaps market. Aside from cross‐border disputes, in the presence of regulatory arbitrage, there are concerns that market participants may increasingly seek out jurisdictions with less strict regulations, thereby shifting the risk rather than mitigating it, and eventually increasing the opaqueness of swaps markets rather than bringing more transparency to them.

Moving to less heavily regulated jurisdictions would be a form a physical or geographical migration of the swaps market. Another form of market migration entails converting swap positions into equivalent futures positions, resulting in what could be called the ‘futurisation’ of swaps. Neither the physical migration nor the futurisation of the swaps market would likely have been the market response intended by regulators.

In order to reduce their clients’ exposure to compliance costs associated with the new rules imposed on swap transactions and to avoid dealing with the increased complexity facing swaps market participants (compared to futures market participants for example), the Intercontinental Exchange (ICE) has already converted all existing over‐the‐counter (OTC) cleared energy swaps and option products, including crude and refined oil, natural gas, electric power, and natural gas liquids, into economically‐equivalent futures and option products on 15 October 2012, which corresponded to the compliance date for several new swaps rules. ICE further argued that already tested futures market regulations give market participants more certainty than the untested regulation in swaps markets. Similarly, Chicago Mercantile Exchange (CME) also announced the launch of a deliverable interest rate swap futures contract on 3 December 2012, which will convert or be delivered into an OTC swap that is cleared by the CME upon expiry.

Exchanges are introducing these swap‐like futures contracts to avoid complexity, cost and the lack of regulatory certainty. Of course, the success of these new products is still to be tested. Sufficient market liquidity and trader confidence are essential to the survival of these new products. If successful, a new era may indeed begin for swaps markets, though not quite in the sense intended by regulators.

*This article first appeared in the International Energy Agency’s Oil Market Report dated 13 November 2012.