The advantages and disadvantages of the futurisation of swaps and the

regulators drive to regulate the OTC markets

Recently, derivatives have been widely used to manage company risks. Swap, one type

of derivatives, is defined by Mishra and Debasish (2007) as an agreement of two parties to

exchange periodic payment within an agreed time period. The derivative can be traded as a

standardised contract in an exchange-market or a tailor-made one in an over-the-counter (OTC)

market (NAPF, 2013). According to an NAPF (2013) and an NSA (2013), exchanging derivatives

on OTC markets leads to several risks such as market risk, counterparty risk, operations risk,
and transparency issues. The OTC derivative market is also blamed as a main factor causing

the US 2008 financial crisis as stated by Jenner (2013). To respond to the financial crisis and to

increase transparency in trading through OTC markets, the Dodd-Frank Act in the United States

and the European Market Infrastructure Regulation (EMIR) in the European Union (EU) were

enacted (Guo, 2015). Acworth (2013) argues that these financial reform legislations force the

migration from trading in OTC swap marketplace to futures marketplace, introducing the
futurisation of swaps. There are benefits and drawbacks of the futurisation of swaps and the

differences between both legislations, which will be discussed in the following essay.

In the United States, Title VII of the Dodd-Frank Wall Street Reform and Consumer

Protection Act (Dodd-Frank) is known as the Wall Street Transparency and Accountability Act

of 2010. The Dodd-Frank imposes the regulatory regime on OTC derivatives under the control

of the Commodity Futures Trading Commission ( CFTC) and the Securities and Exchange

Commission (SEC) (Morrison and Foerster, 2010). Dhanji and Royall (2012) state that the two

main objectives of Title VII are to minimise risk of the US financial system and increase
transparency in the OTC derivatives market. According to Aditya (2013), in order to achieve

these goals, all swaps trading in OTC markets are encouraged to trade subjecting to regulatory
supervision via Swap Execution Facilities (SEFs) and Organised Trading Facilities (OTFs). The

author further notes that OTC swaps must be centrally cleared post- execution at a central

counterparty (CCP) and reported to swap data repositories (SDRs). Moreover, Aditya explains

that the Act requires OTC swaps market participants to register as a swap dealer (SD) or a

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major swap participant (MSP) according to normal course of business. Once SDs and MSPs

register, regulators set the capital and initial margin requirements to ensure the safety and
soundness of the SD and the MSP and to deal with the risk of uncleared swaps (Morrison and

Foerster, 2010).

In European countries, the EMIR was introduced with the aim of mitigating risks
associated with the derivatives and improving transparency. There are three primary obligations

on market participants under the EMIR. First is the obligation of clearing where a CCP is

required to clear OTC derivatives between market participants. Loeffler and Miller ( 2016)

indicate that in the UK, the Bank of England has authorised ICE Clear Europe Limited as a
CCP. Secondly, reporting obligation, all derivatives traded in OTC or exchange will have to be

reported to a trade repository authorised by the European Securities and Markets Authority
( ESMA) . This obligation aims to improve transparency by reporting the information to

regulators. Last but not least, in terms of risk mitigation techniques, this obligation is applied

in respect of OTC derivatives that are not cleared via a CCP which aim to mitigate operational
and counterparty credit risk (Condat, 2013).

According to Janda and Rausser (2011), the regulatory framework of the EMIR and the

Dodd-Frank are similar. The purpose of both regimes is to fulfil the G-20 commitments that a

CCP is responsible for clearing all standardised OTC derivative contracts. Furthermore, the

contracts should be traded on online trading platforms or exchanges, and reported to trade
repositories. Although the Dodd-Frank and the EMIR regulations are similar in terms of the

scope and general definitions allowing for most derivatives, there are some differences
regarding the regulatory responsibility as well as clearing and trading requirement. In the

following paragraphs, these differences will be outlined in more detail.

Aziz (2010) compares both regimes associated with OTC derivatives markets. The first

difference between the two regulations is regulatory responsibility. Under the Dodd-Frank Act,

the oversight over the derivatives markets is divided between swaps overseen by the CFTC

and security-based swaps overseen by the SEC while the EU regulatory jurisdiction does not

divide the regulatory oversight over swaps and security-based-swaps but the regulation under

the EU regime requires the permission and mandate of the ESMA. Moreover, in the US, the

2
regulation will be overseen only at the federal level whereas in the EU regime, EU member
states can impose the national regulatory authorities, and the regulatory authorities will take
place at a national level which is subject to the ESMA oversight. The second area of differences

between the US and the EU regimes as stated by the author is clearing and trading requirements.

Under the US regulation, all swaps which are subject to the mandatory exchange trading
requirement are also necessary to be executed on an exchange or the SEFs but this is not applied
if the trading is excluded from the clearing requirement whereas the EMIR does not propose
any exchange trading requirement for derivatives.

Prior to the establishment of regulation, swaps were traded in the opaque OTC market.

As a result of the Dodd-Frank and the EMIR, OTC swaps are traded transparently via a centrally

clearing and reporting process. In addition, systemic counterparty and operational risk are

reduced. Rosenberg and Massari (2013) explain that burdensome regulation seeks to increase a

cost of swap in two ways: through the requirement of capital and margin and through disclosure

and transparency requirement. As many advantages previously enjoyed in the swap market are

reduced, market participants are discouraged in their use and turned instead to the futures
markets. These lead to the basic idea of the futurisation of swaps.

The futurisation of swaps as defined by Aditya (2013) is the process of moving of swaps

from OTC marketplace to futures marketplace. Market participants trade new product through

the exchange-traded market with futures contract, known as swap futures. Swap futures keep

the customised swap feature in the standardised futures instrument by imitating the swap cash
flows into the futures contract while maintaining the trade in the centralised exchange and
central clearance.

Among the identical features, the Dodd-Frank creates the differences between swaps

and swap futures in the following significant ways. According to Aditya ( 2013) , the first

discrepancy is that the calculation of margin on futures contracts varies and is lower than those
for swaps. Secondly, regarding the rules on price reporting, Riley (2013) explains that after full

implementation, swaps prices are expected to issue the real-time report; however, there is a ten

minute delay in futures prices report. Moreover, in terms of reporting, Riley mentions that swap

price is reported to SDRs while futures exchanges claim the right in their report and charge for

3
data they release. However, there is an exemption in reporting block trade transaction - a trade

level of large notional or principal value between two parties outside the market (ISDA, 2011).

Guo (2015) states that large size of block trade is proposed by the CFTC to trade swaps off the

SEFs. According to the Practice Law Company Finance (2013), unlike the swap market, futures

exchange can set its own minimum level of block trade, which is normally smaller than that set
by the CFTC. These features of swap futures can pose both positive and negative impacts.

There are several advantages of swaps contracts migrating to futures contracts as the
futurisation of swaps. Firstly, Taylor (2013) states that trading on swap futures has a lower cost

than trading on swap because swap counterparties are charged registration and compliance
costs by the dealers. Moreover, the use of futures allows investors to be able to avoid

registration as SDs or MSPs with the CFTC (Aditya, 2013). Therefore, using swap futures will

reduce cost and registration requirements.

Secondly, using swap futures can reduce the amount of initial margin of market
participants. According to a study by Acworth ( 2013) , there is a difference in the margin

requirements between swap futures and swaps. The margin collateral requirements for futures

are based on one-day value-at-risk (VAR)whereas margin collateral requirements for swaps are

based on a five-day VAR. For more customised swaps, an additional margin may be required,

that is, more than five-day VAR. Investors will provide sufficient margin collateral that covers

the number of days of exposure. Thus, the futurisation of swaps requires lower collateral

requirements than swaps.

Another benefit of the swaps futurisation is diminishing the regulatory uncertainty. The

futures exchanges have already been set up and are fully functioning (Aditya, 2013). Therefore,

the infrastructure of swap futures is stable whereas new rules of swaps remain unclear and
unsettled ( Taylor, 2013) . In addition, Kaminski ( 2013) explains that regulation and futures

markets have a long-standing relationship, allowing re-occurring transferability, risk mitigation

and reduction of counterparty risk.

Lastly, utilising of swap futures leads to an increase in the flexibility and easement of
the trade when having highly liquid in the market. Kaminski (2013) indicates that increasing

4
quantity of futures may help diversify product offerings and may contribute to making room
for new contracts in futures markets. For instance, in 2012, there was the migration of 18 trillion

dollars from energy swaps into the futures market, resulting in the larger margin pool and a
market with more liquidity (Taylor, 2013).

In contrast, there are many reasons the futurisation of swaps is not beneficial. The first

drawback of exchange-traded contracts is standardisation which comes up with a narrower

range of pre-defined attributes and flexibility once compared with traditional OTC trades. This

will definitely not match the demands of swap users. For instance, the small market participants

who need customisation to hedge effectively will get into trouble when using these types of
contracts (Hallberg, 2013). Additionally, Aditya (2013) emphasises that since the number of

standardised futures contracts required to hedge a unique position is greater than the number
of swaps contracts required, the operational costs of utilising futures may be higher.

The second disadvantage of the swaps futurisation is basis risk; the mismatch that the
futures contracts or swap transaction may imperfectly move in line with the underlying assets.

Taylor (2013) demonstrates that the lack of flexibility in futures trading can cause a basis risk

which potentially creates some abnormal gains or losses for hedgers.

Another problem that should be taken into consideration is a risk of inadequate

collaterals. Aditya (2013) stresses that with a central clearing system and margining with a lower

rate than the Dodd- Frank implements in swap trades, it can lead to a risk of insufficient

collaterals if the market fluctuates or clearing house fails. In this case, selling the positions of

clearing house may cause financial contagion.

The last downside potential occurs from the inconsistency of minimum level of block
trade as mentioned above. Riley ( 2013) states that as futures exchange manages its own

minimum level of block trade which is generally smaller than the level set in swap market,
almost every swap futures is conducted outside the market, leading to the same problem before
financial reform legislation, leaving transparency and preventing the market from price
discovery.

According to benefits and drawbacks analysis, many researchers believe that the
advantages of the futurisation of swaps outweigh the disadvantages. It is concluded that a

5
significant movement from OTC to futures exchange traded market leads to financial
innovation and stabilisation of financial markets and economies ( Taylor, 2013). Moreover,

traders will take the best position by choosing the most beneficial regulatory scheme provided
by regulators for each trade. Hallberg ( 2013) suggests that brokers ( sell- side firms) should

identify the differences including advantages and disadvantages between OTC cleared and
futurised swaps to determine the most suitable contracts for their customers.

In conclusion, the Dodd- Frank regulation and the European market infrastructure

regulation are introduced to increase transparency of derivatives exchange. Implementing more

regulations causes a significant market movement from swaps to futures. This is an alternative

path to avoid those regulations. These changes provide more benefits to the participant than

non- benefits. As compared with swap, swap futures reduce utilising costs and regulatory

uncertainty, require less initial margin and increase trade flexibility. On the contrary, with

standardised features, swap futures do not perfectly match with consumers needs. This can lead

to the issue of insufficient collaterals and basis risk. Moreover, with block trade policy, there is

an area of opaque price discovery, which does not support the main aim of regulation.

Considering the benefits and drawbacks of the swaps futurisation, market participants should
utilise both of them and select the appropriate position to maximise their outcomes.

6
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