Bloomberg Wants Regulation To Be Fair And Consistent For Some Reason

Publish date:

I confess that I have not followed the swap-futurization thing closely but my assumption was that the politico-regulatory view was:

  • Swaps are evil instruments of financial instability and fraud and should be discouraged, and
  • Listed futures are mostly harmless.

I mean, look around. Swaps blew up AIG, Oakland, Monte dei Paschi, the U.S. housing market, whatever. Futures just blew up those old guys in Trading Places.

You can have various objections to this preference for futures,1 but surely the most compelling is that swaps and futures are to some reasonable approximation the same thing. They're just delta-one exposures to some underlying quantity; calling them a "swap" or "future" doesn't matter economically.

That, anyway, is Bloomberg's line of argument:

Data vendor Bloomberg L.P. filed a lawsuit on Tuesday against the top U.S. derivatives regulator to fight a new rule that would make the trading of swaps more expensive and hurt its business.

Bloomberg is one of a dozen or so providers that plan to launch platforms on which to trade swaps, as regulators globally crack down on the $650 trillion market to prevent a repeat of the 2008 financial crisis.

Under a rule by the Commodity Futures Trading Commission (CFTC), buyers and sellers of swaps must set aside enough money - so-called margin - to cope with the impact of a deal falling apart, assuming it takes five days to unwind the position.

But for futures, a rival type of product, the assumption is that deals can be unwound in one day, making them far cheaper to use.

"These arbitrary requirements are the result of a flawed rule-making process and a patently deficient cost-benefit analysis," said Eugene Scalia, Bloomberg's high-profile lawyer. "The rule will have a serious adverse effect on the market."

Clearing organizations are required to collect initial margin equal to at least 1 day's 99%-worst-case move for futures, but a 5 day move for swaps, meaning that swaps need about twice as much margin.2 And they're the same thing! I mean, they're not really the same thing - swaps are mostly on credit and interest rates, while futures are mainly on orange juice and oil and the S&P and different interest rates - but they will be soon enough, since interest-rate swap futures and CDS futures, which more or less perfectly replicate the economic terms of swaps, are a thing now. In part, as Bloomberg points out, to take advantage of the lower margin rules.

Bloomberg's main objection in its complaint is that the distinction is "arbitrary and capricious" - that the CFTC didn't think hard enough about this distinction, and that it doesn't make any sense.3 Which I guess is right? There's a "who cares" answer to this - if the CFTC arbitrarily drives people to a listed public futures market instead of a somewhat-over-the-counter "swap execution facility," how does that hurt the markets? - to which Bloomberg has a somewhat underwhelming response:

Post-trade swap transaction data are disseminated to the public in real time, free of charge. On the other hand, DCMs [futures exchanges basically] charge fees to access futures data; these fees can be prohibitive and make access difficult. In addition, pre-trade transparency requirements attach to swaps, except where the value of a swap exceeds a certain "block trade" threshold. The "block trade" thresholds for swaps will be set by the CFTC; as proposed, the thresholds were set at levels high enough to ensure that only the largest trades are excluded from pre-trade transparency requirements. And while pre-trade transparency requirements also apply to futures, the "block trade" thresholds for futures are set by the DCMs themselves, which regularly set the thresholds at lower levels, thereby ensuring that more futures transactions evade the transparency requirements.

See, exchange-traded derivatives are less transparent than swaps!

I feel for the CFTC here. Congress basically decided that OTC derivatives were too risky and too fraudy and too secret and told the CFTC to fix everything all at once. And so they tried to, in the face of lots of lobbying and with a personnel set that ... I mean, Bart Chilton is on the CFTC. And they gave it a shot. They took a more or less unregulated swaps market and introduced clearing and margin requirements and disclosure requirements and, doing all those things at once, they slightly overshot the regulation of the futures market in things like margin and transparency requirements. Which you can understand: the swaps market, in the popular narrative, blew up the world in 2007-2008. The futures market didn't.

You can imagine various responses to that. One is for swap market participants to say "yeah, fair point, we were a bit reckless, a bit of overregulation might be just what we need." Hahahaha I mean you could imagine it right? No? Okay, fair. Another is for swap market participants to say "that is no fair and we're suing." That is Bloomberg's approach and they've hired lawyers who've had some success with no-fair-CFTC lawsuits in the past.

The third approach is the road that everyoneelsefollowed: take advantage of the CFTC's overshooting by transforming swaps into futures. Presto, overregulation avoided. Seems much simpler than suing the CFTC.

Also seems like a better long-term plan. Much of the fun, and the competitive advantage, in financial markets comes from finding new ways to do economically identical things in regulatorily favored ways.4 Suing the CFTC to make them treat things with the same economics, but different names, the same, cuts against that. A Bloomberg win that slightly lowers swap margins, at the cost of destroying the whole principle of regulatory arbitrage, doesn't seem all that great for its clients.

Bloomberg v. CFTC complaint [D.D.C.]
Bloomberg sues CFTC over derivatives rules [CFTC]
Bloomberg sues CFTC over cleared swaps margin rule

1.Like: perhaps they cause global famine? That seems like a minority view in the U.S. anyway.

Or: if you dislike high frequency trading/algos/robots/flash crashes/what have you, you might dislike futurization? E.g.:

Algorithmic trading, where computers drive more and more of the price action of the swap is a natural progression to futures, in fact, futures are better placed for that and there are some algorithmic trading firms that have not been able to trade CDS who can now dedicate resources and capital to getting involved in the market.

2.Square root of time. Bloomberg's suit quotes this CME marketing document saying that "[rate swap] futures offer futures-style margining, which equates to margins that are approximately 50% lower than cleared Interest Rate Swaps."

3.For instance - they never asked for comment on the specific 1-vs.-5-day futures-vs.-swaps rule, and they chose those based on what swap clearing organizations currently do. From the CFTC's rule release:

The longer liquidation time, currently five days for credit default swaps at ICE Clear Credit, LLC, and CME, and for interest rate swaps at LCH and CME, is based on their assessment of the higher risk associated with these products. Contributing factors include a concentration of positions among clearing members, the number and variety of products listed, the complexity of the portfolios, the long-dated expiration time for many swaps, and the challenges of the liquidation process in the event of a default.

Bloomberg also argues that swaps should, a priori and as a category, be more liquid than futures, which is a little silly, but whatever:

Because futures contracts-including "swap futures" contracts--can be executed only on the DCM [designated contract market, i.e. exchange] on which they are listed, the liquidity for a futures contract is limited to the DCM on which it is listed. By contrast, swaps can be executed on any SEF [swap execution facility, e.g. Bloomberg's planned thing] (once the rules for SEFs are in place), DCM, or OTC platform. Liquidity for a swap therefore can be found across the entire market, regardless of execution venue.


Liquidation time is closely related to the liquidity in a product: the more liquid a product, the shorter the liquidation time. Because futures contracts-including "swap futures" contracts--can be executed only on the DCM on which they are listed, the liquidity for a futures contract is limited to the DCM on which it is listed. By contrast, swaps can be executed on any SEF (once the rules for SEFs are in place), DCM, or OTC platform. Liquidity for a swap therefore can be found across the entire market, regardless of execution venue.

The global swaps market exceeds $600 trillion in notional value, with some liquid products exceeding $10 billion in notional value per day, while other highly illiquid products may not even trade on a daily basis. Similarly, there are thousands of different futures contracts. Some of these have virtually no volume and do not actively trade.

4.Which reminds me: if you're a derivative structurer you should really read this New York Magazine piece about designer drugs. Relevant:

These man-made compounds were called “designer drugs” in the late nineties; you might have thought, as I did before I researched this story, that they had such a name because they were carried around by trendy types in designer Gucci handbags, but it refers to a chemist’s “designing” a new molecular compound that replicates the effects of an illegal drug. By virtue of being molecularly distinct, these newer synthetics now exist somewhere between the realms of legal and illegal, in the gray. ...

Lapoint starts spitballing about what may happen in the future. “If I was a [research-chemical drugmaker], I’d want to make a structure of an endogenous chemical,” he says, “one that’s already in your brain and [can be enhanced] to hit the right neurotransmitters to get you high. The problem is that if you took this drug out of your brain and tried to eat it, it would be quickly broken down by enzymes. But you could tweak these [naturally occurring] structures, or add a substance that inhibits these enzymes, and you would get a psychoactive effect.” This would surely stump regulatory officials. Lapoint is completely against the proliferation of these drugs—he’s not interested in more patients in his ER. Still, as a man of science, he can’t but marvel at this type of reverse-engineering. “Whoa,” he says. “That would be really cool.”

I know how he feels. Not in a drug way I mean. But what a beautiful regulatory arbitrage.