Swapping swaps for futures

The hottest topic of the day is the migration of swaps to the futures market, which appears to have taken regulators somewhat off guard.  The basic idea is that market participants will prefer to use futures contracts that mimic the performance of swaps rather than using the swaps themselves.  The apparent motive behind this migration is the impending regulation of the swaps market, with the imposition of the usual regulatory requirements relating to margin, block size, transaction reporting, central clearing, swap dealer registration, etc.

On January 31, 2013, the CFTC held a public roundtable to solicit input on the benefits and burdens of this migration.  Written comments can be retrieved from the agency website and a video of the day-long session will be available there soon.  The trade press is also providing extensive coverage of the views of scholars and partisans on this matter.

Certain basic principals can easily be agreed upon, regardless of where one's interests may lie.  Opportunities for "regulatory arbitrage" between the swaps and futures systems should, naturally, be eliminated or at least minimized.  The increased burden on "end users" who use swaps to hedge their actual risks in the marketplace should also be held to a minimum, although that will undoubtedly be a non-zero number.

Where the regulatory lines are drawn, and how they are adjusted with experience, will certainly be a matter of intense debate and unavoidable experimentation; much of this is unexplored territory.  But regulators and Congress must keep the broader picture in mind.  Futures and swaps are often, rightly, analogized to insurance policies.  It is less common to recognize the costs of regulation as part of the premium, as real as that cost is.  Dodd-Frank and its implementing regulations are intended to be insurance against catastrophic failure of the national and international financial system.  The "regulatory premium" for that policy will never exactly reflect the corresponding risk in such a complex and dynamic system, but burdens, fair and unfair, must be borne to provide a better system than the one that exploded five years ago.       

Court vacates CFTC position limits rule

On September 28, 2012, U.S. District Judge Robert Wilkins vacated the CFTC's rule setting speculative position limits on futures, options, and swaps contracts linked to 28 physical commodities, and remanded the matter to the agency for further rulemaking.  The CFTC promulgated the position limits rule on November 18, 2011, as part of its implementation of the Dodd-Frank Act.  The three commissioners voting for the rule -- Chairman Gensler and Commissioners Chilton and Dunn -- believed that Congress had concluded that the limits were necessary to prevent "excessive speculation," preempting any consideration by the agency of the need for the limits.  Although he voted for the rule on the basis that the law required the agency to set position limits, Commissioner Dunn expressed grave doubt as to whether the rule was either necessary or likely to be effective.  Two financial industry organizations -- the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association -- sued under the Administrative Procedure Act, claiming that the Dodd-Frank Act clearly required the agency to make a finding that the limits were necessary before promulgating them.

Judge Wilkins disagreed with both parties, finding that the Act was ambiguous as to whether the agency needed to predicate its rulemaking on a factual finding that the position limits in the rule were necessary to prevent excessive speculation or that Congress had already made this finding when it passed the Act and the agency was without discretion as to whether the limits were necessary.  Judge Wilkins found that the agency proceeded under the mistaken impression that the statute clearly required it to promulgate the position limits rule, regardless of whether the agency found the limits necessary.  He therefore vacated the rule and remanded the issue to the agency to reconsider the rule on the basis that the Dodd-Frank Act is ambiguous concerning whether the agency has discretion to make a finding on the necessity for position limits.

This is the first judicial vacatur of a CFTC rule promulgated under Dodd-Frank.  It will undoubtedly be followed by others, given the extreme complexity of the task and the vigorous opposition the agency faces from a well-financed and sophisticated industry.

Judge Wilkins' opinion in Civil Action No. 2011-2146 can be downloaded from opinion  

Should the Commodities Futures Trading Commission be replaced by a single administrator?

The original purpose of establishing the Commodity Futures Trading Commission as an "independent" regulatory body was to "insulate" it from some of the more turbulent political currents in Washington.  The Commission consists of five Commissioners, no more than three of whom may be from the same political party.  The complexity and speed of the modern derivatives environment argues for a regulator structured for high efficiency.  Congress is the appropriate venue for making high level political choices.  While statutory implementation also calls for policy trade-offs, the opportunity to submit comments on proposed rules -- which, under the law, must be considered by the regulator -- allows for generous public input to the rule-making process.  Congressional oversight of the agency and judicial review of new rules also militate against the potential bias a single administrator might introduce.  A regulator with a politically divided leadership imposes a second round of political negotiating on the process of implementing a statute, with a corresponding delay and potential diffusion of focus in new regulations.

Would the regulation of derivatives be better served by an agency with a single leader -- perhaps appointed for longer than a single presidential term, such as five or ten years?  

Introduction

This blog will examine the evolving world of derivatives in hopes of generating constructive ideas as to how to achieve a better balance between innovation and reliability in the markets.  Recent events, such as the Libor rate fixing scandal, the failure of MF Global, and the collapse of the Peregrine Financial Group, have lend Congress -- among many others -- to question whether the present market structure provides sufficient customer protections to enable effective hedging of risk.  In the coming weeks, I will invite comment on the state of the derivatives markets and provide my own impressions and suggestions in an effort to elicit concrete contributions toward developing more stable and effective markets.