J. Christopher Giancarlo, the newest commissioner of the Commodity Futures Trading Commission, published a white paper that severely criticized the Commission’s swaps trading rules and proposed an alternative framework that he claimed more accurately reflected congressional intent.
When Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, it did not prescribe specific execution methods for cleared swaps, says Mr. Giancarlo. Instead, it “expressly permitted [swap execution facilities] to offer various flexible execution methods for swaps transactions using ‘any means of interstate commerce’.”
Subsequently enacted CFTC rules, which dictate that swaps be executed solely through a central order book (CLOB) or a request for quote (RFQ), are therefore not mandated by statute, claims the commissioner, and are inconsistent with the fundamental nature of swaps as opposed to futures. As a result, says Mr. Giancarlo,
[t]here is a fundamental mismatch between the CFTC’s swaps trading regulatory framework and the distinct liquidity, trading and market structure characteristics of the global swaps markets. This misalignment was caused by inappropriately applying to global swaps trading a U.S.-centric futures regulatory model that supplants human discretion with overly complex and highly prescriptive rules in contravention of congressional intent. This mismatch—and the application of this framework worldwide—has caused numerous harms, foremost of which is driving global market participants away from transacting with entities subject to CFTC swaps regulation, resulting in fragmented global swaps markets.
Mr. Giancarlo claims that the distinction between futures and swaps derives from the different characteristics of the products. Futures, he claims, are “relatively fungible products with standardized terms and conditions ... and uniform trading and credit procedures.” Swaps, says Mr. Giancarlo, are far less fungible, and range from very customized instruments with long maturities to more standardized products with shorter maturities.
Swaps tend to trade episodically, while futures tend to trade more continuously, says Mr. Giancarlo. Because a futures contract tends to be the exclusive property of a specific exchange, the exchange generally handles all aspects of trading—from data reporting, trade confirmation and settlement. This is not the case with swaps, where a contract design is not owned by any particular exchange and swaps markets are served by a host of independent third parties who provide trade data reporting, affirmation and confirmation services, says the commissioner.
By limiting swaps that must be traded on a designated contract market or a swap execution facility to be traded solely through CLOB or RFQ functionality, the CFTC ignores fundamental differences between futures and swaps. According to Mr. Giancarlo,
[b]y requiring SEFs to offer Order Books for all swaps, even very illiquid or bespoke swaps, the rules embody the unsophisticated and parochial view that centralized order-driven markets, like those in the U.S. futures markets, are the best way to execute swaps transactions. That flawed view is not reflective of global swaps market reality.
Mr. Giancarlo recommends that, instead of continuing with overly proscriptive regulation governing SEF trading rules, the CFTC should encourage flexibility consistent with the congressional mandate. He advocates vehemently that trade execution methods should be permitted to evolve “organically based on technological innovation, customer demand and quality of service.” He also suggests that professionals involved in swaps markets should be required to demonstrate qualification similar to professionals in the securities and futures industries (e.g., by passing required examinations).
Mr. Giancarlo claims that adoption of his vision for the regulation of swaps trading “will achieve Congress’s express goals of promoting swaps trading and market transparency in a well-conceived regulatory framework without exacerbating systemic risk and market fragility.”
My View: Although I tend to agree with most of Mr. Giancarlo’s recommendations (and am still thinking about the others), my path for getting there is slightly different. To me, it is not that all swaps behave one way and all futures another that they should be regulated differently—it is because some swaps are much less liquid than many futures. However, many delivery months of futures are equally illiquid as are many strike prices of options. Regulators, particularly in the United States—because of artificial divisions created by law—, have gotten it wrong when they base regulation on the name of the product they are overseeing rather than on its characteristics. It is simply not relevant whether a financial product is called a futures contract, a security or a swap. What is relevant is solely (1) whether a financial product is sold for future settlement (where payment now represents a partial down payment to ensure performance later), (2) how distant in the future is the settlement scheduled, and (3) if a financial product that is sold is settled today, can the product be purchased on leverage and, if yes, for how much and what are the conditions? Moreover, at any time, how liquid is the financial product today and over time? Viewing the characteristics of products rather than their names would permit regulators to develop more appropriate trading and business conduct rules. It certainly would avoid scenarios where cleared swaps can be transformed over a weekend to cleared futures, options can be regulated both as securities and futures, and highly correlated but differently named financial products can have different regulatory and tax treatments. Congratulations to Mr. Giancarlo for an exceptionally thoughtful think piece!