CFTC Shows Anticompetitive Behavior With Swap Margin Rules

By Neal Wolkoff, Richardson & Patel, LLP

Originally published on Tabb Forum 

Another lawsuit may be headed the CFTC’s way over the implementation of Dodd-Frank rules, and the terror of administrative agencies, Eugene Scalia, may be filing it on behalf of Bloomberg. Mr. Scalia, a partner at Gibson Dunn, prevailed on behalf of ISDA in its suit challenging the CFTC’s imposition of position limit rules. He also beat back an SEC rule-making -- but I am not commenting on that; I’m just pointing out his success with the financial regulators.                     

This time, Scalia is representing Bloomberg L.P., which intends to launch a SEF (an exchange designed for the execution of swaps trades), but is objecting to the CFTC’s rules that would require interest rate swaps to have a margin requirement covering a possible price move over a five-day period.

Interest rate swap futures, and futures in general, do not have any CFTC margin mandate; instead, they have margins set by the exchanges, usually to cover a possible one-day price move. The additional collateral requirements for swaps would clearly cost investors more than maintaining a comparable position in interest rate futures. 

Considering all the effort and fuss made by the CFTC and Congress to make sure that swaps are an “open access” market, unlike the vertically integrated trading and clearing operations of the major futures exchanges, this proposal would certainly drive business to the futures exchanges under a “closed access” model and hurt the new entrants to swaps executions that hope to compete.

And, in the case of interest rate swaps, the margin requirements for SEF-traded positions compared to exchange-traded positions does not make sense. Margins are put in place to protect the clearinghouse and its members from the default of another clearing member. Margin requirements are intended as a buffer to protect any clearing member, and thus the clearinghouse that guaranties that clearing member, from having to meet a customer’s loss with its own funds. The thought is that a futures contract can be liquidated immediately should the need arise. Of course, some futures contracts may be too illiquid to provide for quick liquidation of a failed position and should require more than a one-day margin coverage.

Interest rate swaps, on the other hand, are very liquid, and their economic risk can always be hedged with euro-dollar futures contracts should liquidity unexpectedly dry up. The risk, in other words, is less with an interest rate swap than with a thinly traded futures contract, yet the CFTC allows the futures contract to be margined at a far lesser level than the highly liquid swap. 

The CFTC has, at best, a small body of direct experience in setting margin requirements, and it has rarely if ever intervened in an exchange’s margin decision. The CFTC’s blanket rule on swaps margins takes away the decision on proper margin levels from the clearinghouses, which really do have the expertise to evaluate risk and determine appropriate margin levels.

Bloomberg is looking to compete in the interest rate swaps space that Dodd-Frank envisioned opening to robust market competition. The CFTC’s one-size-fits-all margin rules for the swaps markets are indeed arbitrary, and show the agency pulling its punches when it comes to seriously laying the foundation to open the largest segment of the over-the-counter derivatives markets to competitive forces.