Discuss the Advantages and Disadvantages of the Futurisation of Swaps and the Regulators’ (in the Eu And/or Worldwide) Drive to Regulate the Otc Markets

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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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References

Luke Zubrod, (2014) “Four year later: dodd-frank and derivatives”, Institutional investor, August 01.

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