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.

Bank Losses Sharpen Focus on Proprietary Trading*

On 10 May 2012, JP Morgan, the largest US bank by assets, announced that poorly designed and executed hedging strategies had caused more than $2 billion in derivatives trading losses from transactions in London. Even more worrying is the fact that some regulators, including the US Commodity Futures Trading Commission (CFTC) and the US Securities Exchange Commission (SEC), have argued that since they do not yet monitor JP Morgan as a swap dealer, they became aware of the trading losses after JP Morgan’s announcement despite earlier media reports at the beginning of April that raised red flags over the London Whale’s $100 billion notional exposure in one credit index. Even the regulators, the US Office of the Comptroller of the Currency (OCC) and Federal Reserve Bank, failed to detect the risk posed by the massive hedging strategy, despite having more than 100 of their own staff embedded at JP Morgan, up until April, around the same time that Bloomberg and Wall Street news reports suggested that the UK-based trader at the bank was playing a dominant role in certain markets and distorting prices.

Volcker Rule: Grounds for Divorce?*

In a narrow 3-2 vote on 11 January 2012, CFTC Commissioners proposed their own version of the Volcker Rule, which prohibits proprietary trading activities of banks and limits their investments in private-equity and hedge funds in line with the restrictions already proposed by the Federal Deposit Insurance Corp., the Federal Reserve, the SEC and the Comptroller of the Currency in October, 2011. The intent of the Volcker Rule is to reduce risk in the US banking system by limiting the excessive risk-taking activities of banking entities, defined as any insured depository institutions and their subsidiaries.

OTC Market Regulations: Where Do We Stand?*

Market participants still await final rules which will govern global OTC derivatives markets. Meanwhile, according to the latest Bank of International Settlements (BIS) survey, total notional value of all OTC derivatives reached $601 trillion at the end of December 2010, of which $2.92 trillion (0.5%) was commodity–related derivatives. However, at their peak at end‐June 2008, the total notional value of commodity derivatives had reached a far higher $13 trillion, or 2.5% of the total market. Although the size of commodity‐related over the counter derivatives contracts is relatively small compared to the overall OTC derivatives market, new regulations will have important implications for commodity markets in general, and energy markets in particular.

How Transparent Are Crude Oil Derivatives Markets?*

Increased volatility, higher crude oil prices and the arrival of new financial participants in the crude oil market during the last decade have raised the question of whether financial players have an impact on commodity prices and price volatility. Unfortunately, limited publicly available data in both physical and financial markets makes it very hard to provide a definitive answer. Understanding the linkages between physical and financial markets on price formation requires more complete information on both than is currently available. Traders in derivatives markets rely on signals from current and expected physical fundamentals , but these signals can be distorted by imperfect or delayed information flows Therefore, it is crucial to have more timely and reliable information from physical markets in order to address the observed volatility as well as to determine the influence of different market participants on prices.

Volatility: Not Unique to Exchange-Traded Commodities*

Fluctuations in commodity prices, particularly in crude oil prices, have been hotly debated in recent years. Some argue that underlying market fundamentals, especially the unexpectedly strong demand shock attributed to continued strong economic growth in Asia and other emerging economies, is the main reason for the resurgence of commodity prices and for the fluctuations in prices since 2004. Others argue that speculative activity in commodity derivatives markets is the main force behind surging commodity prices. They further claim that commodities have become a new asset class in investors’ portfolios, and prices are now more affected by macroeconomic news rather than by commodity-specific physical market conditions.