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

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UNIVERSITY OF STRATHCLYDE

DEPARTMENT OF ACCOUNTING AND FINANCE

M.SC. FINANCE AND

M.SC. FINANCE AND INVESTMENT

2016/17

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: DERIVATIVE AND TREASURY MANAGEMENT

 DAKSH SALUJA                                                201662719

 MAYUR ASHOK KANKANI                                201666670

 PAYAL KUMAR                                                201684220

 SHASHANK DINESHCHANDRA GUPTA                201675804

        LECTURER IN CHARGE – DIMITRIS ANDRIOSOPOULOS

                  WORD COUNT- 1980

                DATE OF SUBMISSION

           10th MARCH, 2017

According to Aditya (2013), futurization is the transition of swaps onto the futures exchange from the OTC swaps market. The new chapter of futurized swaps and other Over the counter derivatives is facing some of the issues i.e., collateral reductions, risk mitigation and multilateral position netting across various pools of counterparties (Kaminski,2013). The new swaps future are new variants of swap contracts which are meant to replicate the existing features of swaps. To link, “futures are related to forwards as swap futures are to swaps” (Kaminski, 2013). The new swaps futures contract is a hybrid product which seeks to contain personalized features of swaps while transacting on a centralized exchange to give relief to existing OTC swaps traders. (Aditya, 2013). Delivery options and block trading would become convenient on futures exchange. Modifications and exceptions will ultimately make new swaps (future swaps) fit somewhere in the gray zone (uncertainty) in the middle of traditional futures and traditional swaps contracts (Kaminski, 2013). Swap futures are an attempt to trade swaps, but do so under the regulation of the futures market as futures contract have inherit benefits. The conversions of cleared OTC swaps into futures, as well as the advent of swap futures, mimic a swap under a futures wrapper (Aditiya,2013)

Futurization of swaps may come across as being a relatively recent development, however, a lot has been done in the past to try and regulate the existing OTC Derivatives market.  Congress passed The Dodd-Frank Act in America and the European Market Infrastructure Regulation (EMIR) were introduced in 2008. This was the year; the world saw one of its greatest financial meltdowns – The Great Financial Crisis of 2008. One of the reasons credited to the crisis was the unregulated swaps market and its high rate of default. The swap market, was mainly an OTC-oriented market that aided trade and construction of highly personalized contracts that varied on a number of terms and conditions. In 1974, the Commodity Futures Trading Commission (CFTC) was set up to regulate the futures market in order to regulate swap dealers of America by improving transparency and introducing clearing houses in the equation of a swap Trade. However, their authority over the OTC derivatives market was never well outlined and consequently there were many problems faced by the unregulated OTC market as stated by. Halm-Addo (2010) sheds some light on the same and cites this confusion to be the main reason for the CFTC to have faced a number of lawsuits.

Given how extremely personalized an OTC swap is, the market was extremely difficult to regulate due to the degree of variability of the assets traded. Crucially, this made the OTC derivatives market, prior to 2008-09, decentralized and difficult to administer effectively.  Dodd-Frank and EMIR aimed at regulation and convergence of trading of listed and OTC derivatives on one unified exchange. This was crucial to improve transparency and exercise greater control over the swap Market. Also, it aimed to reduce the risk associated with default on behalf of counterparties by introducing the role of clearing houses in the process.

   The main issue associated with Dodd-Frank is that it possesses limited capacity to eliminate the risk factor. Interestingly, it transfers the risk to another participant of the transaction – the clearing houses. By involving clearing houses, the liability of a default lies with the clearing house. This, in contrast, implies that clearing houses deal with risk management for liquidity purposes whereas they were built to deal with risk of default by counterparties. Phillip Stafford (FT, 2015) raises another cause for concern on how there are only a handful of institutions that are authorized to clear swap agreements. By concentrating this responsibility, in one major market, the regulation could possibly create a monopoly. Also, in the situation wherein a Clearing House runs into trouble, how will they be bailed out? Importantly, can the new regulated system, potentially be concentrating and amplifying the risk component which may eventually affect the market?

 As an answer to this criticism, there are many central institutions in America and Europe that are developing and improving institutional framework of the Derivatives market as well as the Clearing Houses, in the case of such a crisis. Imeson (Wolterskluwerfs, 2017) sheds some light on how the new Recovery and Resolution Regulation proposal for Clearing houses, issued by the European Commission in 2017, can help bail out such institutions if met with a crisis.

Aditya (2013) advocates that futurization of swap would reduce regulatory burden as swaps have high cost of registration and a high compliance cost to ultimate users in the form of higher monetary fees, however use of swap futures allows market participants to cut back the nominal volume of their swaps, protecting Swap dealers or Major swap participants from the burdensome registration procedures with the CFTC. “Regulatory arbitrage encourages market participants to pick more advantageous regulatory schemes for cost saving, accounting, tax, or other purposes. The comparative clarity of regulatory schemes now favour futures”. (Taylor ,2013). As per the report of CME group (2013) The stringent capital requirements under Basel III have changed the requirements of capital and associated cost for financial institutions. The degree of customization offered by the product has direct relationship with the transaction costs. As the margin accounts of futures require less collateral, it becomes more attractive for investors as compared to swaps. The initial and variation margin requirement in futures is less as compared to swaps i.e. in swap, margin requirement includes a 5-day value at risk charge (VAR), while in futures margin requirement is 1 day VAR charge. Highly Customised swaps require additional margin in excess of five-day VAR subject to CVA Var under Basel III. Thus, the higher margin requirement of swaps makes the total activity of trading swaps inefficient.

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