COLUMN-Regulators win as ICE converts swaps to futures: Kemp
By John Kemp
LONDON Aug 6 (Reuters) - IntercontinentalExchange (ICE) last week surprised the derivatives world by announcing that all its over-the-counter cleared energy swaps will be converted to futures contracts from January 2013.
Most market participants had expected these products to be brought within the framework of futures regulation after new rules implementing the Dodd-Frank Act reversed the previous advantages for OTC swap contracts compared with exchange-traded futures.
But few expected it to happen so quickly. It is a marked victory for governments seeking to ensure that all standardised products will be traded on exchanges or electronic trading platforms and fulfils one of the promises made by G20 leaders at their summit in September 2009.
"Increasing the proportion of the (derivatives) market traded on organised platforms is important so as to improve transparency, mitigate systemic risk and protect against market abuse," according to the OTC Derivatives Working Group of the Financial Stability Board.
Cleared OTC swaps were already traded on an electronic platform and subject to margining rules. But the transition to futures status should boost transparency and bring them into a clearer regulatory framework.
ICE announced that OTC cleared swaps for North American natural gas, electric power, environmental products and natural gas liquids (NGLs) will be listed as futures on ICE Futures U.S. Cleared oil products, freight and iron ore swaps will be listed as futures on ICE Futures Europe in London.
The conversion is subject to approval by futures regulators in the United States and the United Kingdom.
"We anticipate a seamless transition that will largely preserve existing methods of transacting in ICE's markets," ICE President Chuck Vice promised in a press statement on July 30.
FORWARDS, FUTURES, SWAPS
In the United States, futures contracts have attracted stricter scrutiny and tougher regulation than other contracts since the Grain Futures Act of 1922 (and in some individual states the nineteenth century). Most other countries have followed suit, creating a distinct and tougher regulatory environment for futures dealing.
But rules covering "contracts for future delivery" have always excluded "any sale of any cash commodity for deferred shipment or delivery", creating a strong incentive to ensure agreements are classified and treated favourably as forward delivery contracts rather than futures ones (7 USC 1(a)(17)).
The U.S. Commodity Futures Trading Commission (CFTC), which has authority to regulate futures but not physical forward transactions, has spent decades struggling to work out a way to distinguish clearly between the two, generating an enormous body of law.
Under Dodd-Frank, the CFTC's jurisdiction has now been extended to cover swaps, but again the term "swap" has been defined for the purpose of regulation to exclude "any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled", mirroring the distinction between futures and forwards. (7 USC 1(a)(47)(B)(ii))
The CFTC has promised to extend its current practice of distinguishing between futures and forwards into the swaps market.
"Under the Commodity Exchange Act, the CFTC does not regulate forward contracts. Over the decades, there have been a series of orders, interpretations and cases that market participants have come to rely upon regarding the exception from futures regulation for forwards and forwards with embedded options," CFTC Chairman Gary Gensler told a public meeting of the commission last month.
"Consistent with that history ... the Commission is interpreting (the exclusion for physically settled swap contracts) in a manner that is consistent with Commission precedent and, in response to commenters, is providing increased clarity on the forward exclusion from futures regulation," he promised.
"The final release provides guidance regarding forwards with embedded volumetric options, like those used within the electricity markets, and is requesting comment on this interpretation."
1991 BRENT INTERPRETATION
The CFTC has already had to confront the distinction between futures and forwards after a U.S. District Court ruling in 1990 that forward transactions involving crude oil from the Brent oil market were in fact futures contracts that needed to be traded on a contract market regulated by the CFTC.
"Many oil traders began shifting their operations offshore, and foreign traders refused to deal with United States entities. Brent oil market volume declined significantly," according to Professor Jerry Markham's magisterial "Financial History of the United States".
In 1991, "the CFTC tried to stabilise the situation by issuing a statutory interpretation that stated that Brent oil contracts were not subject to the exchange trading requirement of the Commodity Exchange Act" according to Markham, in what became known as the "Statutory Interpretation Concerning Forward Transactions" or simply the "Brent Interpretation" (55 FR 39188).
In line with this, "the primary purpose of a forward contract is to transfer ownership of the commodity and not to transfer solely its price risk," the CFTC explained in its recent rule-making. "The CFTC's historical approach to the forward contract exclusion ... developed on a case-by-case basis, not by rule." ("Further definition of a swap" publication pending in Federal Register)
Under the Brent Interpretation, forward contracts are entered into between commercial market participants and create binding obligations to make and take delivery without providing an automatic right to offset, cancel or settle by paying differences. Any cancellation or offset requires a separate subsequently negotiated agreement, and any party can refuse to agree to it.
"It is well established that the intent to make or take delivery is the critical factor in determining whether a contract qualifies as a forward," the CFTC observed in a 2010 legal case. The commission has consistently applied a "facts and circumstances" test to assess whether the parties to a contract expected or intended physical delivery.
CUSTOMISED OR STANDARDISED?
Like forward transactions, swaps were historically exempt from CFTC oversight. For years, derivatives users and dealers argued that OTC swaps were much more customised than exchange-traded futures contracts and could not therefore be traded on exchanges and should not be subject to the same regulatory regime.
It has long been clear that the customisation of many OTC swap contracts was designed in part to win better regulatory treatment.
While some OTC contracts were tailored to help hedge the precise grade, quality, location and delivery requirements of commercial users, others were simply generic copies of futures contracts that benefited from a more favourable regulatory treatment, including exemption from position limits and reporting.
Fresh rules under Dodd-Frank have reversed that favourable regulatory treatment. In some ways, OTC swap contracts will now attract less favourable treatment than exchange-based futures.
"Based upon our extensive analysis of new swap rules and consultations with a wide variety of customers," ICE explained, "we believe that these policies will increase the cost and complexity for swaps market participants, both in absolute terms and relative to that of futures market participants." (here)
University of Houston Professor Craig Pirrong analysed the issue on his Streetwise professor blog last week: "Nothing changes but the name." He went on, "the contracts are already standardised, traded on an electronic platform and cleared. This is not a movement of bespoke, uncleared, bilateral contracts onto an exchange.
"It's long been known that the economic substance of swaps and futures are effectively identical, especially when the former are cleared," Pirrong wrote. "Changing the label - hell, call them bananas - doesn't change the economics. If the CFTC had less burdensome regulations for bananas, ICE would launch ICE Bananas."
Pirrong has been critical of Dodd-Frank and much of the CFTC's rule-making. In this instance, he appears to argue that the sole outcome will be another round of regulatory arbitrage. ("A swap by any other name" Aug 2)
Arguably, however, ICE's decision to re-label its cleared swaps as futures suggests regulators have won this round of the battle, ensuring that all contracts with an economically equivalent purpose will be treated in the same way, rather than subject to an artificial distinction.
More arbitrage seems inevitable in the future, especially around the loophole for swaps contemplating physical delivery. For now, however, ICE's decision suggests regulators have notched a victory. Dodd-Frank is working exactly as was intended.
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