History is, at least from time to time, a cyclical thing, it seems, and the US Commodity Futures Trading Commission (CFTC) is as alive as anyone to the ironies of the revolving wheel of fate. Commodity markets in the US go back to the 1800s, with Federal Regulation of the agricultural commodities markets dating from the passing of the Cotton Futures Act in 1916 and the Grain Futures Act of 1922. The overseeing body at the time was the Department of Agriculture, which was logical, since agricultural commodities were the entire extent of the futures market.
However, the nascent energy and metals markets were on the horizon and by the 1970s Congress decided that the DoA had enough on its plate with its day job and created a new agency, the CFTC, to regulate the futures market.
At first that market did not need to be defined since it was “obvious” to everyone involved that futures were agricultural futures. Those days of blessed clarity soon vanished however. By the 1980s people had begun to try to use futures type contracts to take the risk out of many other kinds of price movements over time, including interest rate movements and currency movements. The swaps market had arrived, and with it, the over-the-counter (OTC) derivatives market – the same market that acted as such a catastrophic amplifier of bank bad practices in the run up to the 2008 global crash.
As the CTFC says, its mission has always been to “protect and foster the crucial risk management and price discovery functions of the futures markets” by being relentless in detecting and deterring fraud, manipulation and abusive trading practices. As the swaps market gathered speed around it, the CFTC naturally asked itself if it should be broadening the scope of its responsibilities to catch this new market.
When the Head of the CFTC put this to the US regulators of the day at the Securities and Exchange Commission and the Federal Reserve, they damn near had a stroke. To say it wasn’t a popular suggestion would be putting it oh, so mildly. The swaps market and the burgeoning derivatives market generally was regarded as the engine of financial innovation and the key to the next phase of America’s wealth – not something that, in a world of light touch regulation, anyone in power wanted to see the CFTC bearing down on.
However, that was then, and this is now. As the CFTC chairman Gary Gensler reminded his audience at the Annual Dinner of the National Economists Club, on November 9 this year swaps may have grown up as bilateral trades outside the scope of the CFTC’s remit, but that laissez faire approach ended in tears:
“…unregulated swaps were at the center of the 2008 financial crisis. Taxpayers bailed out AIG with $180 billion, for example, when that company’s ineffectively regulated $2 trillion derivatives portfolio nearly brought down the financial system.”
Having rebuffed the CFTC’s suggestion in the late 1990s that it look after the swaps market, Congress has now turned to the CFTC to generate the rules that will implement the Dodd Frank Act’s new entity, the swap data repository, and to write the reams of additional rules required to bring regulation to the swaps market.
The swaps market is in an uproar, naturally, with relatively casual players not wanting to get themselves classified as swap dealers or “major swap participants”, both of which categories will be heavily regulated under Dodd Frank. The CFTC is very keen to talk to everyone and anyone with an interest in the rule writing process so that it can minimise the law of unintended consequences.
The benefits, the CFTC is keen to stress, lie not just in preventing more AIG-like snarl ups in the financial sector. Bringing transparency to the swaps market will aid price discovery for all participants. Dodd Frank wants all standardised swaps to be traded on regulated exchanges or through swap execution facilities, open centralised marketplaces where prices are publicly available. Inevitably swap dealers will face capital and margin requirements that do not exist at present. Major swap participants might be similarly affected. And standardised swaps will be cleared through a clearing house, reducing counterparty risk.
The rule writing task before the CFTC is enormous and it will be working closely with the Securities and Exchange Commission, a body that it has a long history of not exactly seeing eye to eye with. However, both organisations have committed to playing nicely with each other, with numerous joint working parties looking at areas of mutual interest. At the very least this project is likely to generate some interesting case study material for Harvard post-grads for years to come. It may even do a decent job and not kill off the swaps market…
Further reading on the swaps market:
- Understanding and Using Currency Swaps, a QFINANCE checklist.
- Understanding and Using Inflation Swaps, a QFINANCE checklist.
- Swaps, Options, and Futures: What They Are and Their Function, a QFINANCE checklist.
- Derivatives Markets: Their Structure and Function, a QFINANCE checklist.
Tags: CFTC , Commodity Futures Trading Commission , currency swaps , inflation swaps , interest rate swaps , regulation , SEC