If Congress really had its way (well, the Democrats anyway) than all swaps would have been forced to look and trade like futures. If you’re reading this blog than you know that would be a classic square peg, round hole. Case in point: Eurex launched iTraxx futures some years back and no liquidity every developed. But times have changed, and although I’m not completely convinced the world needs credit-default swap (CDS) futures, the upside if the contracts are successful is big enough that it is nearly inevitable that they will come to market ahead of CDS trading and clearing mandates later in 2012. Why?
Firstly clearinghouse margin requirements for CDS are seen by many as unnecessarily high. Complications related to clearing sovereign and bank CDS, two of the most highly used CDS segments, will leave margin requirements for those products even higher than for index CDS. These high margin requirements alone could open the door for CDS futures as the margin requirements for futures are tracking much lower than for comparable swaps.
Hence my comments to Dow Jones. CDS futures won’t take off just because the market wants to take directional bets on credit, they’ll take off because they provide an economic incentive to those wanting to take direction bets on credit:
Kevin McPartland, principal at the independent research firm TABB Group, said these so-called “liquidity” issues would drive more trading in CDS and “that would only translate to demand for CDS futures” so long as they offered some economic benefits over the existing swap contract.
A dealer working on the CDX futures project said it could be a solution that would drive volumes because the contracts could be traded in smaller sizes than CDS, and this could appeal to investors not currently trading in swaps. “It’s something that makes sense,” he said.
Over the last few weeks the topic of CDS futures has come up a bit in my conversations with industry participants. In fact we discussed this back stage at our recent Fixed Income Trading 2012 event in New York on January 24th. Everyone seems convinced that several firms are “working on the problem”. However, a TABB Group estimated 80% of CDX.IG trading in the interdealer market happening electronically based on a highly standard contract (remember the Big Bang in 2009?) begs the question, with such a standard, relatively liquid market already in place why do we even need a future? Its nothing more than a different regulatory rubber stamp calling the product one thing over another.
It can even be argued that margin rates for cleared CDS and the comparable cleared CDS future should be the same. If they’re economically equivalent than why wouldn’t margin requirements be equivalent? That point leads to another discussion that I’ll come back to in the coming months.
The bottom line – someone will bring CDX.IG futures to market, but betting on their success is purely a game of chance. Only time will tell.
Clearinghouses don’t remove risk. In fact, they concentrate it.
But that concentrated risk is mitigated by the structure of the central clearing model. More specifically, position-based margin requirements and minimum excess capital requirements for members create a cushion to absorb losses in the event a member firm collapses. That largely removes the risk from the system. This is nothing new.
Adapting that model to meet the demands of a clearing mandate for much of the over-the-counter derivatives market, however, changes things.
TABB Group has pointed out several times that clearinghouses must be able to value the products they clear so they can accurately margin them. For futures contracts – most of which are relatively liquid – this process is easy since the last trade price provides an accurate valuation.
For OTC derivatives, however, liquidity in most products is shallow, which causes clearinghouses to mark to model. Some models are relatively straightforward (interest rate swaps are mostly just about predictable cash flows) and others less so (CDS valuations take into account probability of default – a guesstimate by its very nature). To account for this complexity, the big OTC derivatives clearinghouses in the U.S. are using the tools at their disposal, margin and capital requirements.
Margin requirements will make trading more costly for many market participants used to trading bilaterally, but most concede that margin is needed because it is the primary tool for clearinghouses to reduce risk. Capital requirements, however, are raising a lot of eyebrows.
Here are the facts:
The minimum capital required to be a broker-dealer, as set by the Securities and Exchange Commission, is $250,000. The minimum capital required to be an FCM, as set by the Commodity Futures Trading Commission, is $1 million (derivatives are more complex and have more leverage built in, after all). To be a futures clearing member of CME Clearing, the capital requirements are higher: $5 million. Each of these amounts increases based on a number of factors including number of clients, open positions, etc. but for the sake of comparison we’re going to focus on the minimums.
Enter OTC derivatives clearing. To be a clearing member at CME to clear interest rate swaps, the minimum capital requirement is $1 billion. To clear CDS at ICE Trust U.S., the minimum capital requirement is $5 billion (as mentioned above, CDS are a more complex product to clear). This would lead us to believe that clearing an interest rate swap is 200 times riskier than clearing an interest rate swap futures contract.
But is it?
The aforementioned clearinghouses have of course run countless scenarios over many months to ensure the soundness of their clearing model. A common approach is to simulate the default of two clearing members simultaneously and then ensure that the clearinghouse could continue to function properly. If those tests show that billions in excess capital are needed per firm to keep systemic risk out of the picture, then it is what it is.
But the disparity leaves me confused. Either minimums on one side are too low or minimums on the other side are too high.
Time will tell.
The CFTC should stick to regulating markets and not try to regulate data center providers. The recently released proposal by the CFTC does a good job of preventing providers of data center space from competing on their merits and pricing according to market demand. Don’t get me wrong, I appreciate the spirit of the proposal –make pricing transparency and allow “all qualified market participants willing to pay for the services” to gain access. However, the wording leaves me wondering how some providers could stay in business.
All “that offer co-location and/or proximity hosting services must ensure that there is sufficient availability of such services for any and all willing and qualified market participants.”
This sound reasonable. If someone wants in and can afford it, they should be allowed access. The validity of the statement is killed in the next line, however: “if the availability of a service became limited, thereby leaving some market participants or third-party hosting providers without adequate access, the Commission would not view access to those services as open and fair.” So does that mean if Equinix, CME or NYSE runs out of space in their data centers they will be out of compliance until they can build out new real estate? Data centers are not virtual assets; they cannot be expanded at the push of a button. Despite a huge push to increase the inventory of prime data center space in major market centers square footage and more importantly the power to support is very much finite.
The provision relating to ‘‘Fees’’ would ensure that fees are not used as a means to deny access to some market participants by ‘‘pricing them out of the market.’’
What happened to supply and demand? Isn’t that what a capitalist society is based on? If trading firms are willing to pay $10,000 per server cabinet and the provider can sell enough of those cabinets to stay in business, then there should be no issue. Only a few paragraphs’ prior in the proposal, it states that “equal access” means providing services to those “participants willing to pay for the services.” A good portion of trading firms in the US do not use trading strategies with enough latency sensitivity to make paying the premium for co-location necessary or a worthwhile business expense. And of those, many can in fact afford it but don’t need that access – a.k.a., they are not willing.
By all means, the CFTC should encourage all co-location providers to disclose pricing and availability, but let’s not mess with the supply and demand economics that make the US capital markets some of the most efficient in the world.
I could go on, but I think you see the problem here. Time for the CFTC to go back to the drafting board.