This blog post originally appeared on FOW. It was also covered in the John Lothian Newsletter.

As global regulators move to implement new rules designed to control the swaps markets, the world’s futures exchanges are responding with bold and innovative structural changes intended to reduce or eliminate certain regulatory burdens faced by their customers, including increased trading costs and additional expenditures associated with alternative risk management processing methods.

As a basis for the change, the Dodd-Frank Act and the subsequent regulatory definition of a swap expressly exclude futures and options on futures. As a result, on October 15, the Intercontinental Exchange (ICE) intends to convert an entire class of over-the-counter cleared swaps into listed futures. This change is meant to ameliorate some of the negative effects of the Dodd-Frank rule-based disparate treatment among swaps and futures, including higher margin costs. Through this action, the ICE effectively creates a hybrid instrument class that will trade, margin and clear as futures, yet concurrently adhere to the enhanced segregation and protection rules under the new swaps regime.

The new segregation rules, which generally apply to swaps pursuant to Section 4d of the Commodity Exchange Act, impose enhanced requirements onto brokers to segregate their customers’ funds to protect against fellow-customer risk that is inherent in the futures clearing model. The ICE has effectively answered this regulatory burden by modifying its rulebook and implementing structural efficiencies through the identification of a hybrid instrument class known as “covered product.” The ICE is contemplating a covered product that is functionally equivalent to a future/option and simultaneously receives the segregation benefits attributable to swaps. The introduction of the covered product also alleviates customers’ increased trading costs that are a likely result from the newly imposed gross margin rule.

Because the ICE as a designated contract market (DCM) may self-certify its contracts as futures, at first glance the transition to covered products look as though the ICE is attempting to circumvent or avoid swaps rules through a simple re-classification of its products, which under certain circumstances may be construed as evasion and would constitute a Dodd-Frank rule violation. However, the ICE swaps-to-futures transition, and concurrent introduction of covered products is likely compliant because the covered products anticipate being cleared through the Section 4d account, which explicitly satisfies the Dodd-Frank rule implementation. That is, although cleared and managed as futures/options, from a segregation perspective, the ICE is treating covered products as swaps together with the enhanced protections.

From an operational perspective, covered products also solve for what would be additional expenditures associated with alternative risk management processing methods. Accordingly, the CFTC Rule 1.73, which sets forth pre-trade risk management requirements, would apply to clearing members that are FCMs, and Section 23.609 would apply to clearing members that are SDs or MSPs. Under the rules, clearing members of a designated clearing organization (DCO) would be required to establish risk-based limits and trade compliance for each account based on position size, order size, margin requirements, and/or similar factors. This means that all participants – even those that are not involved in agency business – need to comply with Rule 1.73, with the requisite technology. Finally, the rule contemplates that only authorized trades within the parameters set will reach the market, providing the member firm is operating within a pre-defined limit schedule.

Although the CFTC has stated that it “envisions that each clearing member will comply with Rule 1.73 using procedures and technology appropriate to its business model and customer base,” by establishing and maintaining systems of risk controls reasonably designed to ensure compliance. However, trade origination complexity exposes many member firms to violations because of the source, method, or structure of the trade. Therefore, the move toward covered products and re-classification provides operational relief to the DCOs customers. This is true because covered products, such as those being introduced by the ICE, contemplate the continued use of an industry-standard pre-trade risk management and position monitoring system providing high-capacity control across multiple markets and products. Although the CFTC does not prescribe the manner of risk limits, it envisions member-based filters and configurations that can be set either to auto-reject orders or to notify the trader with an alert which may be adjusted to a particular market or product.

More significantly, the introduction of covered products and re-classification is a foreseeable trend, as other clearinghouses will likely provide similar relief and innovation. In fact, CFTC Commissioner Scott O’Malia said “the decision by ICE to speed up the transition of its cleared OTC energy contracts to futures reflects regulatory uncertainty, and is likely to be replicated by other exchanges.” The ICE has likely moved to modify its rulebook and re-classify its swaps contracts because market participants have expressed concerns about issues ranging from increased collateral demands, gross margin netting burdens, and inflationary trade costs, as functionally disruptive to the current state of clearing and trading activities.

Specifically, beginning on November 8, gross margin rules require that initial margin should be determined with respect to each customer position on the same basis that the clearinghouse would determine margin on the account of an FCM, thereby requiring market participants to hold these related positions in separate accounts with separate margin requirements. Therefore, the ICE seeks to preempt collateral demand changes and inflationary trade costs by introducing the covered product.

Additionally, and consistent with this trend, the CME Group is rolling out a new product called “swap futures,” in mid-November. In addition to independent trading viability, swap futures are intended to provide ancillary support to privately negotiated swaps that may trade off-facility, or possibly on affirmation platforms such as swap execution facilities (SEFs). Like the ICE’s covered product, the CME’s swap futures are hybrid instruments and seek to reduce initial margin costs by calculating on a portfolio or netted basis rather than the gross basis under the new rules. Also, swap futures are standardized to account for position limit scheduling and pre-trade monitoring on a multi-dimension level – including market, desk and individual client, as required by the rules, and without any additional risk management processing configuration.

Swap futures and covered products introduced by the world’s futures exchanges contemplate economic and structural innovation through products that are compliant, efficient and able to leverage industry-standard pre-trade risk management and position monitoring systems. As Dodd-Frank continues to drive change, it looks like this is only the beginning for exchange and clearing innovation.

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