Department of Accounting and Finance

2017/2018

“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”

AG925 – Derivatives and Treasury Management

Group 15
Chatoglou Evlampia 201789578
Gkortzis Dimitrios 201787317
Moschopoulos Christos 201768519
Tsitsos Ioannis 201768527
Tzavidas Panagiotis 201774398

Lecturer – Dimitris Andriosopoulos

Word Count = 2120 10/03/2018

In accordance with the European Commission (2012), it is noticeable to refer that the
95% of derivatives are exchanged in over the counter (OTC) markets. At the same time,
as it is reflected by the Financial Crisis of 2008, the Commission mentions the
correlation between substantial risks and OTC markets, coercing so governments to
modify the regulation οf ΟTC markets, in οrder tο manage financial stability.
Notwithstanding, Benos, Payne and Vasios (2016) notice that the passage from swaps
to futures includes both positive and negative side and it was primarily occurred
because of the pressure imposed on financial institutions by this regulation.

To commence with, the extensively existence of derivatives traded in ΟTC markets has
arisen many concerns not only for the participants, but for the market stability as well.
Among others, Awrey (2012) remarks the difficulties to specify the riskiness of
derivatives due to their complicated market. He argues the existence of casino-style
conditions, mainly because of the uncertainness and the shortage of knowledge for
market participants. More particularly, he demonstrates this by utilizing two significant
markets such as UK and USA, which permitted this market delirium to be carried on
by espousing a non-regulated apprοach. According to him, this policy was entirely
against market tendency since financial innovation increases with the passage of time,
assisting the creation of advanced instruments established in ways that rise the necessity
fοr further regulation. Consequently, swift financial innovation composes a strong
evidence of the necessity to control much more efficiently the framework of markets,
instead of allowing them to operate out of the rules. Furthermore, Natiοnal Centre fοr
Pοlicy Analysis strongly accused the usage of credit default swaps (CDSs) since they
led to the expansion of risk and subsequently, to the“cοllapse”of crucial financial
institutiοns”(Dakers, 2016). Additionally, Dickinson (2008) claims that the speculative
usage of these securities which were principally created for hedging, caused the
formation of harmful asset bubbles. Trying to support this statement, he reports the
instance of AIG, which was nationalized in order to deal with liquidity problems that
faced, because of the mistreatment of CDSs. Taking all these into consideration, it can
be easily observed that the reasons led us to the financial crisis were complicated and
any effort to determine possible solutions must be multinational.

The meeting of the 20 most pοwerful economies in Pittsburg in 2009 was one of these
actions. As Kelly and Cho (2012) and Bonciu (2010) state, the main incentive of this
summit was to analyze and adopt a new policy and regulation. The leaders recognized

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the necessity for an international reformation to be carried out, which set the base for
the financial regulatory framework applied on a global level. According to the
International Swaps and Derivatives Association study, countries espoused various
methods to abide with the G20 incentives (CFTC,2013). For instance, China did not
only introduce the China Foreign Exchange Trade System, which performs foreign
exchange transaction reporting, but it also started using the clearing house rules in
February 2016. Additionally, in India services like trade reporting and clearing were
being performed by the Clearing Corporation of India Ltd. The ISDA research showed
that central clearing is encouraged by regulators in order to mitigate risk on these trades.
Furthermore, regulators in Australia imposed that every derivative market activity must
be reported; the perspective behind this is the authorization of central counterparty
clearing for Australian dollar interest rate derivatives.

Concerning Europe, the European Commission Communication (2009) had set as a

target the transparency augmentation and systemic risk reduction. In order this to be
achieved, many safety measures were established; European Market Infrastructure
Regulation (EMIR) and Markets in Financial Instruments Directive/Regulation
(MiFID/MiFIR) constitute typical examples of these enactments. Awrey (2012)
mentions that the primary purpose of these regulations was to diminish the number of
the private derivatives market, where the central clearing requirements and the adequate
regulatory supervision were absent. Regarding MiFID, Ferrarini and Saguato (2013)
explain that this regulation totally transformed the European financial markets and
created two new legislation segments. The first one was the MiFID II, a modification
of MiFID, which focused on the investment services transaction norms, and the interior-
exterior governance requisitions for investment companies and exchanging venues. The
second one was the MiFIR, which imposed mutual rules for all European Union
members that were focused on the compulsory dealing of derivatives. The dsiclosure
of trade-transparency data and the entrance to exchange venues and clearing facilities
without discrimination were few of them.

Referring to U.S, similar inducements led to the formation of the Dodd Frank Act in
July 2010. Sweet (2010) mentions that the primary aims of this Act was to reinstate
public confidence in the economic system, minimize the possibilities for another
financial crisis. Moreover, van der Weide (2012) describes that the Dodd Frank Act
provided regulators and Federal Reserve more power and control in order the financial

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consistency of the country to be protected. The author also notes that the extensively
keeping of records and reporting on swaps trades were compulsory, in order to avoid
market manipulation and fraud.

However, as it is mentioned above, the implication of these regulations has been defined
as the foremost reason for the passage of swaps to futures. According to Rosenberg and
Massari (2013), futurization of swaps is the “prοcess of” conforming the terms of
transactions of an OTC swap contract in order this can be listed οn an exchange. The
enactment of these measures was intensively cost, and therefore, trying to avoid the
highly regulated OTC market, market participants preferred to futurize their swaps. As
a result, they started trading new products, known as futures, but combining also the
advantages οf swap transactiοns. However, both advantages and disadvantages within
this process do exist.

On the one hand, perhaps the main positive consideration in relation to futurization of
swaps is the lower margin requirements compared to traditional swaps. Kornfeld and
Nowak (2017) declare that, margin collateral requirements for cleared swaps are based
on a 5-day value-at-risk charge, where futures at the same time are based on a 1-day
value-at-risk charge. Following this strategy, sufficient margins have to be set by
derivative traders, in respect of the number of days of exposure. As a result, all swap
dealers and major swap participants would be required to collect and post initial margin
for inter-dealer transactions; a considerable amount of liquid collateral would be locked
up, thereby significantly raising the margin of traditional swaps. Since swap margin
requirements will be increased for market participants, it will give investors an
incentive to take advantage of it and join futurization.

Another positive aspect, is that on the post Dodd-Frank Act period, swap futures
generated more benefits for the participants of these derivatives contracts as far as cost
concerned. Kaminsky (2013) states that the cost of trading with futures is significantly
lower in comparison with traditional swaps. According to the author, swap
counterparties face additional costs as dealers, since it is required by them to register as
swap dealers (SPs) or major swap participants (MSPs) with CFTC. These registration
and compliance costs will may be transferred to end users, in the form of additional
fees or higher spreads.

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In addition to OTC swaps according to Rosenberg and Massari (2013), new regulatory
framework evidence is still debatable and there is no any empirical evidence that
provides the reduction of risk in OTC swaps under these new rules; futures regulations
are linked with an already well know and successful trading history, so their structure
is more stable and transparent (Hathaway, 2013). Having traditional swaps traded under
futures regulations, will boost investors’ confidence to the market, and will also reduce
regulatory uncertainty.

Furthermore, a final argument in favor of the migration of swaps to futures is the

possibility of creating new futures contracts to satisfy the demand for swap futures.
According to Taylor (2013), Toledo (2015) and Hahn et al (2013), ICE transitioned its
energy swaps into futures contracts; at the same time, CME's vast majority of energy
trades migrated to its futures exchange platform. Energy are not the only type of swaps
where has been noted a significant transition to futures. Eris Exchange now offers
interest rate swap futures. Consequently, the big collection of futurized swaps that have
become available to the market, make futures contracts more diversified and this will
provide margin efficiency. The standardized nature of futures makes this connection
harder, causing more obstacles in risk reduction. To summarize, the aggregation of both
swap and futures margins will create a new, bigger margin pool, providing liquidity to
the market.

On the other hand, the opponents of swaps futures claim that there are drawbacks of the
migration of swaps into future exchanges too. The first one is the regulatory arbitrage
that may take place in favor of futures products. According to Taylor (2013) regulatory
arbitrage occurs when traders exploit the differences of the regulation between swaps
and futures in order to choose the most favorable regulatory strategy for each trade.
Litan (2013) in his work concerns that these similar financial products are traded in two
non-identical venues that are regulated in two very different ways. The author claims
that the migration of traditional swaps to less protected and more monopolized futures
market may have uncertain aftermaths. Kaminsky (2013) shares the same ideas and
adding that regulatory arbitrage may lead to asymmetries in fees, information and
collateral across alike contracts.

Another problem of futurization of swaps is the obligatory clearing from CCPs. Among
others, Roe (2013) and Griffith (2012) have pointed out that despite Central

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Counterparties are systemically important and may reduce counterparty risk, they
transfer that risk to the outsiders. In all the above Taylor (2013) adds the too big to fail
concern for clearing houses and their vertically integrated clearing and executions
which has raised concerns for critics of Dodd–Frank’s resolution mechanism for
systemically important financial institutions. The reason, according to Roe (2013), is
that, in the event of default or bankruptcy of one counterparty, it is more than possible
the default member may owe to other parties outside the netting system. By providing
the collateral to the clearing house the collateral is unavailable to those outside parties
in order to mitigate the systemic risk. As a result, the futurization of swaps instead of
reducing risk, it strengthens the systemic risk to non-members.

A further disadvantage is the difficulty of swap futures to mimic the traditional swaps
as far as the provision of access to wide and exclusive products such as weather swaps,
carbon emission swaps and inflation swaps. Taylor (2013) argues that this problem
occurs because the formers are highly customized, while swap futures neither provide
such product depth nor it is economically worthwhile to hedge these risks in futures
contracts. Even in the event of possible futurization of such unique products there is a
probability of causing basis risk to a member (Aditya, 2013). More specifically the
author states that, unlike traditional swaps, swap futures are standardized, so it may be
a mismatch between the hedge and the underlying liability, causing the contingent for
immoderate gains or losses from hedging. Therefore, the absence of versatility in
futures products may raise basis risk and may portend an institution's incapability to
properly book the transaction under hedge accounting rules.

A final concern that has been posed about future swaps is the lack of transparency.
Traditional swaps are reported in real-time while futures are reported on a 10-minute
delay. Toledo (2015) claims that, these minutes can have a negative impact to the
market since a counterparty can exploit this time difference and make a profit out of it.
Transparency reduction is also highlighted by Taylor (2013) mentioning that future
prices can be obtained providing a fee charge, whilst prices on swaps are publicly
available via data repositories, without any additional charge. Duffie (2013) shares the
same opinion giving a third reason why exchange traded swaps are less transparent.
The author refers to the different method of block trade classification. As far as it
concerns futures, each designated contract market (DSM) can set its lowest trading
block requirements; meanwhile this minimum amount is set by CFTC for swaps. With

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the absence of a block trading limit, swap futures can be traded in OTC markets where
pre-trade transparency is absent.

Taking everything into consideration, the financial crisis of 2008-2009 had a

considerably negative impact in OTC markets. Therefore, the enactment of regulation
in order tο increase transparency was more than desirable. However, because of these
differences, there has been a passage of swaps to futures, a process called “futurizatiοn
that had controversial outcomes. To our way of thinking, if the target is to achieve
financial contrοl and stability, the regulators shοuld enact rules that can be implemented
across all financial markets.

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 REFERENCES

Aditya, P. D. (2013) European Markets Infrastructure Regulation (EMIR) and Dodd-

Frank Wall Street Reform and Consumer Protection Act (DFA): A New Revolution of
OTC Derivatives Towards Transparency. Available at:
https://ssrn.com/abstract=2314998

Awrey,D. (2012) Complexity, Innovation, and the Regulation of Modern Financial

Markets. Harvard Business Law Review, Vol. 2, Issue 2, pp. 235-294, Oxford Legal
Studies Research Paper No. 49/2011, Available at: https://ssrn.com/abstract=1916649

Benos, E., Payne, R. and Vasios, M. (2016) Centralized trading, transparency and
interest rate swap market liquidity: evidence from the implementation of the Dodd-
Frank act, Working Paper No.50, Bank of England, 15. Available at:
https://www.bankofengland.co.uk/working-paper/2016/centralized-trading-
transparency-and-interest-rate-swap-market-liquidity-evidence-from-the

Bonciu, F. (2010) 'The Global Economic Crisis and G20 Summit of April 2009: A Step
Forward Towards Better Global Governance or Global Covernment?', Romanian
Journal of European Affairs, Vol. 9, No. 2
Commodity Futures Trading Commission (2013) Public Roundtable On Futurization
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n13_013113-trans.pdf

Dakers, M. (2016) 'Warren Buffet issues a fresh warning about derivatives timebomb',
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warning-about-derivatives-timebomb/

Dickinson, E. (2008) Credit Default Swaps: So Dear to Us, So Dangerous. Fordham

University School of Law. Available at: https://ssrn.com/abstract=1315535

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Duffie, D. (2013) Futurization of swaps: Stanford’s Duffie Offers Another Viewpoint
on This Emerging Trend. Available at:
https://www.darrellduffie.com/uploads/policy/BGOV_FuturizationOfSwaps.pdf

European Commission (2012) Regulation on Over-the-Counter Derivatives and Market

infrastructures – Frequently Asked Questions. Available at:
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European Commission (2010) Review of the Markets in Financial Instruments

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Kelly, C. and Cho, S. (2012) 'Promises and Perils of New Global Govrnance: A Case
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