Streetwise Professor Craig Pirrong: "Back to Futurization - The Consequences of Swap-O-Phobia"
Commentary by Bob Zwirb
Professor Craig Pirrong ("Back to Futurization: The Consequences of Swap-O-Phobia," Streetwise Professor," (Feb. 2, 2013)) analyzes from an economics perspective the trend involving the conversion of swaps into futures, a.k.a., the "futurization of swaps," that was the subject of a recent CFTC public roundtable and two past commentaries of ours published in the Cabinet. (See Zwirb comment of Jan. 31, 2013 and Lofchie comment of September 4, 2012.) Pirrong states that the main driver for this trend is the different regulatory treatment of the two products, a differential that favors futures over swaps. According to Pirrong, the differential makes little economic sense, since the products involved are economically equivalent, and that this equivalence is borne out by the similar experiences of the CME and LCH in managing the default of futures and swap positions in the Lehman bankruptcy. He argues that "imposing differential margins based on a name difference - rather than economic differences - can't make things better, and could well make them worse."
Commentary
In our previous comments on this development, we likewise observed that the transition from swaps to futures was in name only, and that it was motivated by the CFTC's completely disparate regulatory treatment of futures (which are favored) and swaps (which are disfavored). We also observed that, notwithstanding this motivation, the CFTC does not seem alarmed at the apparent end-run around its rules for swaps. Rather, it appears that the agency views it as a positive, with the chairman recently remarking that in the wake of such rules, it's only "natural . . . for some realignment to take place."
But that realignment is motivated not by natural market forces but by artificial regulatory forces that create, according to Pirrong, an artificial advantage for futures and an artificial burden for swaps. Long before the CFTC's construction of what Pirrong calls a "two-sizes-fit-all" regulatory regime, the financial markets were moving toward a clearing model for swaps with the exchange of futures for swaps and the development of a new class of instruments called "cleared OTC derivatives." Indeed, the CFTC initially was quite accommodative of this trend. The OTC market, in other words, was already evolving, albeit incrementally, into the kind of marketplace that Chairman Gensler is aspiring to create. But rather than allow this movement to proceed naturally, Congress and the CFTC in the wake of the financial crisis apparently decided to jumpstart the process. The result, as we have previously noted, has led to a flight of market participants from the new regulatory regime created for swaps to the old one for futures, creating an internal form of regulatory arbitrage within the CFTC's own space.