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New U.S. swap rules could bring the market one step back as well as two steps forward. The Dodd-Frank Act of 2010 aimed to shine light into formerly dark corners of the derivatives market. But some swaps are reappearing as futures. That market is regulated and fairly transparent. But capital and disclosure requirements aren't quite as tight as lawmakers intended for swaps.
Dodd-Frank called for much of the $250-trillion swap market – previously transacted on a bilateral or over-the-counter basis – to move through clearing houses and exchanges. For transactions between big market players, known as dealers, that's a requirement from Monday. Clearing helps to limit risks by setting capital requirements, ensuring that exposures are netted against one another and creating a paper trail. Rules on exchanges are still some way off, but Wall Street is already looking for ways to defang them.
One trend is the so-called futurization of swaps. Many fairly standard forms of swaps, like interest-rate instruments, can easily be converted into futures. Then they become subject to futures regulation, which the 2010 law mostly left alone since that market already utilized clearing and exchanges.
The CME Group openly advertises the somewhat less onerous regulation in the futures market in its marketing for interest rate swap futures. It boasts 50 per cent lower margins than cleared swaps, which require more capital be set aside than futures. For traders, lower capital commitments mean the potential for more profit – and more risk-taking in total.
Futures exchanges of course offer more transparency than the old OTC markets. But they have some dark alleyways, too. For large blocks, for instance, futures trades can take place over the phone. Some exchanges have lowered the minimum size of trade exempted in this way from electronic markets. At least in theory, that sidesteps some of the improved price clarity that lawmakers sought in passing Dodd-Frank.
Futurization involves other wrinkles. The swap execution facilities mandated by Dodd-Frank would make clean data freely available – not always the case with futures exchanges. The swaps rules also mandate open access for clearing, while futures exchanges can end up as effective monopolies with high transaction fees. But unless watchdogs tighten futures rules to match, this particular brand of regulatory arbitrage is likely to continue.