Dodd-Frank Reform: Wrestling Over Remaining Issues

After years of wrangling and wrestling over financial services reform, Dodd-Frank is kicking into effect. In March, category one players started central clearing of OTC derivatives. Category two players come on stream in June, and category three starts in September. Moreover, we’re starting to get a better feel for how market participants intend to position themselves.

For example, GFI Group recently submitted an application to open a proprietary U.S. futures exchange. News reports say BGC is revamping ELX Futures, and ICAP may launch futures in London on ISDX (formerly PLUS). But what structure will these venues take, what are the benefits to launching a futures exchange, and how can these venues differentiate the contracts they list?

Firms can register as a Designated Contract Merchant (DCM) or a Swap Execution Facility (SEF). Dodd-Frank allows DCMs to list futures and swaps, whereas SEFs can only list swaps. The advantage of going the DCM route is the rules already exist, whereas the SEF rules don’t exist yet. The delayed rules are driving SEF wannabes like ICAP crazy because they’re spending a hefty sum of money preparing for launch without bringing in revenue to offset the expense.

What’s the holdup?

Under Dodd-Frank, trades have to be reported as soon as technologically practicable. However, reporting on block trades can be delayed so the liquidity provider has time to hedge the risk. As far as the CFTC is concerned, “technologically” means electronic, so trades have to be done electronically unless they’re a block. Yet there are other times when buy side firms just want to trade over the phone — a good example is in illiquid markets. And why not, as long as the call is recorded and the trade is reported in a timely fashion. One could argue the voice trading issue is pretty bogus, but that doesn’t mean it’s going away.

Then there’s the issue of RFQ 2 and RFQ 5. The CFTC said trading must be conducted on a central limit order book or through an RFQ process. If customer trade is being crossed, it has to be exposed to the market for 15 seconds. But should buy side firms have to show the RFQ to two or five dealers?

I recently spoke to Chris Ferreri, managing director at ICAP about this. He argues that the RFQ issue is a red herring, and it makes no sense holding up the SEF rules on its account. An RFQ can be as simple as “make me a market on 100 5s.” That RFQ doesn’t increase price transparency because there’s no price stated in it. There’s no direction either, because the buy side firm is asking for a two-way market. The RFQ includes an amount, but the buy side firm may have more to do. The maturity is transparent. The downside of the RFQ process is five dealers know that a buy side firm is looking to execute a trade in the market, and chances are the firm doesn’t want to share that information.

Back to the products

Derivatives traders will probably be able to choose from several flavors of OTC and standardized products — some will be look alike contracts and others will be differentiated. Ferreri points to a couple unsuccessful attempts to launch look alike futures contracts in the past: specifically, Eurex’s Eurodollar contract and BrokerTech Futures’ treasury futures contract. He blames their failure on the vertical model for trading and clearing futures contracts, clearinghouses’ unwillingness to accept contracts that compete with their own products, and the concern over lack of fungibility.

The concern about lack of fungibility is understandable for a physical futures contract. If a trader buys 10,000 bushels of wheat on an exchange, then that exchange is responsible for delivering 10,000 bushels of a specific quality wheat to a given location at a certain time. Contracts must be in place with farmers, grain elevators, railroads and truckers. In the case of a cash-settled financial futures contract, one could argue the fungibility argument is weaker because cash is fungible.

Finally, there could be battles over intellectual property because futures contracts are patented. For example, Goldman Sachs owns the patent on the CME interest rate swap futures contract.

Financial market participants don’t like lack of clarity, and they’re not particularly fond of change either. The sooner issues such as voice trading and RFQ 2/RFQ 5 can be resolved, the better. As for the venues and products that emerge and their potential viability – I guess we’ll just have to wait and see.

 

Interest Rate Swap Futures: Comparing Apples with Apples

An upside of the new financial market regulations is that they can be a lever for innovation and an impetus to form new partnerships. We’re already seeing evidence of this happening with the futurization of interest rate swaps.

Both Eris Exchange and CME Group list interest rate swaps futures contracts based on IMM dates. Yet Eris’s swaps futures contracts compete with and complement CME’s offerings. Eris clears its swaps contract through CME’s clearinghouse and can portfolio margin with the CME deliverable swap future (DSF) as well as Eurodollar and Treasury futures. Moreover, Eris hopes to be able to offset margin against OTC swaps contracts, offering clients a full suite of portfolio margining.

The unique feature of CME’s contract is that it’s deliverable. If a position isn’t offset or rolled forward prior to the maturity date, it becomes a cleared OTC swap. The owner of the futures contract posts margin based on 2-day VaR calculation. If the position turns into an OTC swap, the owner posts margin based on a 5-day HVaR calculation.

The Eris offering is a differentiated product that always remains a futures contract. If a contract isn’t offset, it enters the effective period of the swap futures and the forward period. The margin continues to be calculated on a 2-day VaR in the futures guarantee fund.

Eris’s product accrues price alignment interest (PAI) for the life of the trade, and it settles to the OTC swap curve. For example, a firm that has a futures contract constructed as a 5-year forward period on a 5-year swap may receive PAI for all 10 years. If the firm did the same trade on the CME, kept rolling the DSF for five years (20 rolls), and then took delivery of the 5-year swap, it would have missed out on five of the 10 years of PAI. Practically speaking, the market would price that into the bid-ask of the contract, but the firm would still incur the spread as the contract is rolled forward.

The CME futures contract is priced in 32nds whereas the Eris contract is priced on NPV. This provides friction between the two products resulting in trading opportunities in both contracts.

Both exchanges list 2-, 5-, 10- and 30-year benchmarks. Eris also lists Eris Flex products, enabling firms to construct futures contracts to manage duration or match their cash flows. For example, they could combine a forward period with a benchmark contract to execute a contract with the maturity in 7 years and 2 months, 23 years or even 40 years. The Eris Flexes are akin to the CME OTC clearing offering following the 5-day HVaR margin methodology. The market may look to these complementary offerings as a switch market between traditional swaps and swap futures.

The category 1 central counterparty clearing mandate only took effect on March 11, 2013, so it’s still early days. It will be interesting to see how market participants change their behavior to dynamically formulate trading combinations between Eris Exchange swap futures and CME’s deliverable swaps futures contracts, and the CME cleared offerings.