Comment: Flawed US rules fragment swaps market

Over the past several decades, regional and national markets for financial products have expanded into a truly global marketplace benefiting economies around the world.

This expansion has included trading markets for derivatives products such as swaps, futures and options that promote price stabilisation for everyday goods like groceries, gasoline and winter heating fuel.

Without these types of derivatives contracts, farmers, manufacturers and utilities would be unable to manage price fluctuations in commodities, interest rates and currencies, leading to increased consumer prices for food and household energy. This worldwide marketplace has now started to unravel.

Global trading in over-the-counter swaps takes place through a patchwork of competing venues for execution and clearing built upon a series of cross-border conventions and protocols.

Holes in the patchwork, however, notably counterparty credit risk, opacity of trading and counterparty exposure to regulators, and lack of intermediary oversight, were set for reform following the global financial crisis.

In 2009, world leaders in Pittsburgh pledged to better regulate emergent global swaps markets through the co-ordinated efforts of national and supranational regulators.

Five years later, global co-ordination is not going well. Instead of collaborating with foreign regulators, the US Commodity Futures Trading Commission (CFTC) developed swaps “transaction level” rules based on the wrong template of the structure of the US futures markets.

CFTC rules included a host of peculiar and unprecedented swaps trading restrictions, such as limiting ways of executing trades to order books and requests-for-quotes, pushing block trades off platforms and treating trades not accepted for clearing as invalid from the outset.

The CFTC then imposed these ill-advised transaction level rules worldwide by using “interpretative guidance” and “staff advisories” based on market participants’ US personhood or employee location, despite the rules’ tangential relationship to their ostensible purpose of insulating the US economy from systemic risk.

The world’s response to the CFTC’s flawed swaps regime has been a swift “No thank you”. Global trading markets have divided into separate swaps liquidity pools between those in which US persons are able to participate and those in which US persons are effectively shunned.

According to a survey conducted by the International Swaps and Derivatives Association, the circa $400tn market for US and euro interest rate swaps, two of the most widely used products for business risk hedging, has effectively split into two over the past 12 months.

Traditionally, users of swaps products chose to do business with global financial institutions based on factors such as quality of service, product expertise, resources and professional relationship. Now, those criteria are secondary to the question of the institution’s regulatory profile.

Non-US persons are avoiding financial institutions bearing the scarlet letters of “US person” in certain swaps products to steer clear of the CFTC’s problematic regulations.

And it is not just American banks that are losing ground, but also US trading institutions, intermediaries and asset managers, as well as the jobs of US-based employees and vendors who support them. The CFTC’s swaps rules have even stymied the development of global electronic trading platforms in favour of traditional phone transactions that allow participants to readily identify a counterparty’s now essential US/non-US regulatory profile.

Fragmentation of global swaps markets between US persons and non-US persons means smaller, disconnected liquidity pools and less efficient and more volatile pricing.

Divided markets are more brittle with shallower liquidity, posing a significant risk of failure in times of economic stress or crisis. In short, market fragmentation caused by the CFTC’s ill-designed trading rules – and the application of those rules abroad – is increasing the systemic risk that Dodd Frank regulatory reform was predicated on reducing.

A world that is just starting to show signs of recovering from the “Great Recession” cannot bear the fractured trading liquidity and increased systemic risk caused by unsound regulations. The solution to sluggish worldwide growth is sound and vibrant markets for global finance, investment and business risk mitigation.

To maintain healthy global markets, we must regulate swaps execution and clearing in a well-crafted and harmonious manner across jurisdictions.

J. Christopher Giancarlo is a Commissioner at the US Commodity Futures Trading Commission