DRW Investments Suit Forestalls CFTC Enforcement Action
Commentary by Bob Zwirb
DRW Investments LLC ("DRW") filed a preemptive complaint against the CFTC. The complaint seeks the finding that DRW did not breach derivatives trading regulations before the CFTC could bring the action against it.
The complaint states that DRW's action "arises from CFTC's stated intention to bring an enforcement action," which would assert that DRW violated sections of the Commodities Exchange Act by allegedly engaging in manipulative activities that involved interest rate swap futures contracts traded on the NASDAQ OMX Futures Exchange and cleared by the International Derivatives Clearing House.
According to the complaint, "the CFTC's theory of liability depends upon a novel and legally untenable claim" that DRW's activity must have been manipulative, since it placed orders at prices differing from those of similar (though not identical) over-the-counter swaps. The complaint claims that DRW's swaps were not equivalent economically because of different cash flows provided for the contract terms of the two instruments, and that the distinction justified the different price levels. According to the complaint, the CFTC's intended enforcement action "would violate DRW's constitutional due process right to receive fair notice of which activities constitute market manipulation, as well as its right to be free from arbitrary and unreasonable government actions."
Commentary
It's highly unusual for the prospective defendant in a regulatory agency proceeding to seek to preempt an enforcement action by suing the agency before it can issue a complaint, let alone to do so on constitutional grounds. At issue is whether the underlying economics of what took place support or refute DRW's allegations of manipulation. Under the CFTC's theory of liability, DRW's trading and quoting of certain interest rate swap futures were allegedly manipulative because DRW did not track the prevailing price closely of comparable uncleared OTC swaps. The CFTC's position is that the settlement price of the futures contract and the swap contracts should be the same, and that, by entering orders for futures at prices that differed from those for equivalent swaps, DRW distorted the settlement price of the swap futures. By contrast, DRW's position is that the prices should not be the same because the two instruments have different cash flows that reflect the differences between variation margin supporting futures and collateral supporting uncleared swaps.
This is really an issue of economic analysis. Last month, Professor Craig Pirrong published an analysis of the dispute that not only sides with DRW, but also goes further in stating that, due to the differences in cash flows between the futures and the swaps, there should have been a differential between the prices of these instruments. Far from engaging in manipulation, Pirrong argues, DRW contributed to the convergence of the futures contacts' settlement price with the fair value of the swaps. What the CFTC is doing, Pirrong concludes, is comparing apples to oranges and insisting that both trade at the same price.
The question that comes to mind immediately is this: what role might the CFTC's economists be playing here? Are they participating in the investigation, or are they shut out of the process completely? If they are participating, then do they agree with the enforcement lawyers' argument that cleared futures and uncleared OTC swaps should trade at the same price? At this point, we simply don't know. But if DRW's account of the events is to be believed, then the CFTC's own Division of Clearing and Intermediary Oversight ("DCIO") concluded in 2011 that a price alignment adjustment between the two instruments was unnecessary.
Another obvious question is whether the CFTC's Division of Enforcement ("DOE") has consulted with the DCIO on this matter. This would not be the first time that the CFTC's regulatory and enforcement divisions did not see eye to eye on an issue of substance. Until recently, for example, a long divide existed between the regulatory and enforcement branches of the CFTC on the issue of delivery as a distinguishing characteristic between futures and forwards. Compare the CFTC's statements on delivery in the Hybrid Release of 1987 and the Brent Interpretation of 1990 (holding that delivery need not be intended nor occur most of the time with every forward contract) to the DOE's position during that period (requiring delivery to be intended and to occur in order for the instrument to qualify as a forward).
This is one of those cases where the economics, which Pirrong characterizes as "kind of geeky" because they involve "convexity differences" between swaps and futures, are more complex than the legal arguments. Yet the economics are crucial to determining which party is right. If Pirrong's analysis is correct, then the CFTC's position is fundamentally flawed, which likely explains DRW's unusual legal actions. If there is more here than meets the eye, however, then a very interesting manipulation case is about to unfold.