A crucial change in the way financial derivatives are packaged and sold on Wall Street is enabling traders to bypass new regulations aimed at limiting reckless speculation, enhancing the prospect of another derivatives crisis, warn some market participants.
Under the Dodd-Frank financial reform law adopted by Congress in 2010, investors are required to set aside significant sums of cash to cover losses on their derivatives trades -- money they could otherwise plow into additional investments. That policy came in response to the financial crisis that began in 2007, when major financial institutions found themselves unable to cover hundreds of billions of dollars in shortfalls on derivatives trades.
But traders have recently forged a path around these so-called margin requirements in order to allow them to harvest larger profits via larger bets: They are repackaging some derivatives known as swaps into another financial product known as futures. Futures are less stringently regulated, meaning investors can stake out larger positions while reserving smaller amounts of cash.
“As the market gravitates to the cheaper platform -- and it’s cheaper because it’s unsafe -- that creates risk for everyone,” James Cawley, CEO of trade execution firm Javelin Capital Markets, told The Huffington Post.
Cawley recently urged financial market regulators to halt the new practice, which is known as the “futurization of swaps.” He argued that the current market dynamic creates a risky new corner of finance that could eventually grow too big to fail, harkening back to the taxpayer bailout of insurance giant AIG, a package that netted out at $134 billion. The insurer nearly collapsed under the weight of losses on credit derivatives.
“In a distress scenario, you basically have what you had from AIG in 2008,” Cawley said. “Then someone has to step in, and we all know who that someone is: the U.S. taxpayer.”
Cawley is not alone in his concerns. At a recent all-day roundtable in Washington hosted by the Commodity Futures Trading Commission, the main regulator in charge of overseeing the American futures and swaps markets, more than a dozen speakers said traders were exploiting the futures market as a means of selling swaps without having to adhere to requirements that apply to such investments.
But executives of companies that operate futures exchanges portrayed the shift from swaps to futures as a healthy progression while dismissing warnings of supposed dangers as distortions that unfairly demean their businesses.
“We’ve decided to move our contracts to the gold standard, the global gold standard of regulation -– U.S. futures –- the standard-bearer if you will, and I’m here defending a ‘futures loophole,’ which is beyond silly,” said Thomas Farley, a senior vice president at InterContinentalExchange. He described the move as a “natural evolution” in the marketplace, while adding that futures exchanges have a demonstrated track record of prudently managing risk.
Those expressing apprehension about the shift from swaps to futures have intensified their call for scrutiny. Those calls first became public in October, when rules came online regulating a slice of the swaps market that deals in energy derivatives -- an area worth about $18 trillion in daily trading value, according to Bloomberg.
A day after the rules became effective, IntercontinentalExchange, which operates a futures marketplace, introduced a suite of new products that enabled swaps traders to become futures traders. More than half of all volume has since migrated into futures, according to data from the exchange. CME Group, another exchange operator, has rolled out swap-like futures worth about $5.6 billion in daily trading, according to data from the exchange. Another futures exchange, Eris Exchange, has $2 billion in swaps-like futures contracts outstanding, according to the Wall Street Journal.
Those sums are a tiny part of the $639 trillion swaps market. But market analysts believe they represent only an initial shift. A survey by Swiss bank UBS of firms in the swaps markets found traders expected they would eventually replace 20 to 25 percent of their swaps portfolios with futures.
Given the enormity of the dollars in any discussion of derivatives trading, the tone of debate on the rules that ought to apply tends to be intense. So it is in this case, as venues for swaps trading square off against counterparts in the futures world, with each standing to capture fees from the other depending upon where the balance is struck.
That said, far from a mere battle over market share, the reshaping of derivatives trading has regulators concerned as well.
At the Washington roundtable, CFTC chairman Gary Gensler said that “some re-alignment, some re-labeling” of swaps into futures was a natural outgrowth of new regulation. But Gensler said he feared a poorly thought-out shift from swaps to the futures exchanges could significantly change the kind of activity that defines the latter market, increasing the risks to the broader financial system.
“We wouldn’t want to lose what’s been a core function of the futures market: both pre-trade and post-trade transparency,” Gensler said.
Those who run futures markets cast that shift as a source of stability in financial markets.
“The futures markets have many, many decades of development and these decades of development are all about transparency,” said Bryan Durkin, chief operating officer at CME Group.
But Lee Olesky, CEO of Tradeweb, an online marketplace, said the “move to futurization may actually lead to less transparency in the market” by subverting one of the main goals of Dodd-Frank: Under the new regulatory regime, all but a few so-called “block trades” must be disclosed to other market participants, enabling regulators to monitor the scope of speculation. By contrast, which futures trades must be disclosed -- and which can be kept private -- are generally left to be determined by the private companies that operate the exchanges.
“You shouldn’t allow for less transparency in one market, and not the other,” Olesky said. “You just shouldn’t.”
The rules that apply to swaps and futures trades also differ markedly on how much money investors must reserve as a margin to cover their losses. Under Dodd-Frank, losses on swaps trades are limited to the parties that engage in the trade. But in the futures market, the consequences of an ill-fated bet can spill out to myriad players, from the brokers who engineer the positions to the clearinghouses that execute the trades. Moreover, futures traders are required to set aside less collateral on their trades -- an incentive to place larger bets.
As a result, the clearinghouses that underpin futures trading appear uniquely vulnerable to systemic problems, warn traders. The two largest futures clearinghouses in the United States -- subsidiaries of CME Group and IntercontinentalExchange -- together handle virtually all cleared futures trading in the United States.
Should those companies find themselves confronting larger losses than they have set aside in reserve, the consequences could spread turmoil to other areas of finance, say experts, noting that CME owns the Chicago Mercantile Exchange and IntercontinentalExchange is in the process of acquiring the New York Stock Exchange.
“A margining regime that favors financial futures over financial swaps runs the risk of increasing systemic risk,” said George Harrington, global head of fixed income trading at financial technology giant Bloomberg LP.
By his reckoning, the trend toward swaps contracts becoming futures undermines the point of the rules under Dodd-Frank, rendering them “arbitrary and capricious,” and “not based on any real risk analysis.”
Long-time observers of derivatives markets describe the shift as merely the latest incarnation of a traditional mode on Wall Street: Speculative capital tends to move where the rules are least stringent.
“Risk moves, risk morphs, but it does not disappear,” said Dan Maguire, head of swap clearing operations for swaps market clearinghouse LCH.Clearnet. “If you jam” swaps trading into a futures exchange, “it’s likely to have some stress, some unintended consequences.”
As many describe it, the previous tendency for money to change hands on the swaps market was an outgrowth of the fact that rules in that area were practically non-existent.
“These contracts were on the wrong platform all along,” said David Frenk, director of research at public interest non-profit Better Markets. “The only reason that they were in the [swaps] platform is because they had some regulatory benefits which now don’t exist.”
Now, he added, futures exchanges have become “really attractive, but for all the wrong reasons,” with the risk that futures markets could be “essentially abusing their stellar track record.”
“If the futures markets behave as they have historically, then this is not necessarily a bad thing,” Frenk said. “If this transforms them, then that’s no longer the case.”