Sometime around the turn of the year, the US Commodity Futures Trading Commission (CFTC) quietly started investigating the exchange of futures for swaps (EFS) market – in which over-the-counter swaps are executed bilaterally before being converted into cleared energy or metal futures contracts. A series of ‘special call’ notices were sent to major dealers, asking for information on trades dating back to at least the start of 2012, and – as a side-effect – baffling the recipients.
The notices contain no information about the CFTC’s motives – and a spokesman for the agency declines even to confirm the existence of the special calls – leaving dealers and their lawyers to guess why the regulator has suddenly decided to probe a market that it helped set up over a decade ago. Part of the answer is that, however it may appear, this is not a sudden change of heart.
“Fundamentally, the CFTC has become suspicious of all off-exchange or privately negotiated derivatives contracts,” says Sharon Brown-Hruska, a CFTC commissioner between 2002 and 2006, who served as acting chairman from 2004 to 2005. “Off-exchange futures contracts are still prohibited under US law, so the CFTC might argue that the swap leg of the transaction was not bona fide, as was argued in some investigations it conducted in the past.” Brown-Hruska is now vice-president in the securities and finance practice at economic consultancy Nera in Washington, DC.
The CFTC has made at least three previous attempts to constrain the broader exchange for related position (EFRP) market – or even prohibit certain types of trades – and after failing on each occasion, some market participants believe the agency has now resorted to playing mind games. “These special calls don’t actually state what the CFTC is collecting this data for. Essentially the government wants information about certain types of transactions and it has the statutory authority to request it without explanation. That said, it’s my belief that by asking questions about these transactions the CFTC is trying to curtail activity and scare people away from using EFS transactions that they are fully entitled to trade,” says one lawyer close to the situation.
The obvious question is – why? Sources close to the investigation state that the focus of the CFTC’s interest – both in the current investigation and in previous regulatory sallies – is a subset of the EFS market known as contingent or transitory EFS.
Fundamentally, the CFTC has become suspicious of all off-exchange or privately negotiated derivatives contracts
A transitory EFS contract involves three separate trades – a bilateral, over-the-counter swap, and the two components of an EFS, in which the futures leg matches the economic terms of the stand-alone OTC swap. The stand-alone swap is offset by the swap leg of the EFS, with the two trades only existing briefly before they cancel each other out and are terminated.
As a result, the two parties are left with the futures leg of the EFS position, which clears at the central counterparty (CCP) of a futures exchange, also known as a designated contract market (DCM). In the vast majority of EFS trades, the CCP in question is CME Group, with contracts clearing through its ClearPort platform.
The contingent element is derived from the fact that the stand-alone swap only technically comes into existence if the futures leg is accepted for clearing – unless that condition is satisfied, the swap is not legally binding, but as soon as it becomes legally binding, the two swaps immediately offset and terminate. If the futures leg is rejected for clearing, the swap does not exist at all because the contingency was not met.
The CFTC may see this as a way to execute a futures trade away from an exchange, lawyers speculate – avoiding the competitive environment of a DCM’s central limit order book. It is illegal for futures to trade off-exchange in the US, with the exception of block trades. In June 2012, for example, Morgan Stanley paid $5 million to settle charges that it unlawfully executed, processed and reported off-exchange futures trades to the CME and the Chicago Board of Trade under the guise of EFRPs. Since the trades were executed non-competitively and not in accordance with DCM rules governing EFRP trades, they resulted in the reporting of non-bona fide prices, violating CFTC regulations.
But it is difficult to make further sense of the investigation without understanding the regulatory decisions that brought EFS products into existence, and the CFTC’s previous attempts to put the genie back in the bottle.
Following the bankruptcy of energy trading firm Enron in December 2001, counterparty risk fears brought natural gas and power markets to a near-standstill – many energy merchants were deemed not to be robust enough for either physical or derivatives transactions. The collapse in OTC volumes also depleted listed energy derivatives trading volumes in the first half of 2002.
This coincided with the launch of the ClearPort platform at the New York Mercantile Exchange (Nymex), which started clearing energy futures in May 2002. Although the facility had no ability to clear OTC energy swaps and Nymex was unsure whether futures exchanges even had the authority to do so, the DCM contacted the CFTC and the two bodies co-operated on a legal structure that would enable energy swaps to clear at Nymex, supporting the bilateral trading model with the added security of central clearing.
“We were looking for a way to convert swaps into futures transactions for clearing – the question was how to achieve that. We came up with the idea that the swap would be two EFPs done back-to-back, so the buyer of the EFS would sell the swap and buy it right back, extinguishing the swap and leaving a futures position. If a buyer was long the swap, now they would be long the future. The CFTC was fully aware of how these trades were being done and – given it had an interest in unfreezing energy markets post-Enron – it was involved in the process of establishing EFS trading,” says Neal Wolkoff, chief executive of Wolkoff Consulting Services and chief operating officer at Nymex from 2001 until 2003.
Though the Commodity Futures Modernization Act (CFMA) of 2000 included statutory exemptions that excluded OTC derivatives from CFTC regulation, commission approval was still needed because the cleared futures leg of the contract fell within the agency’s jurisdiction. In fact, the CFTC was more than approving – it was enthusiastic.
“We saw these EFS transactions as neat products, as a neat concept that would allow energy market participants to do a one-off transaction. It was – and remains – an excellent product for limiting counterparty risk in OTC markets,” says Brown-Hruska of Nera.
“EFS trades were very closely related to the underlying futures contract but the CFTC did not judge that they were too similar to futures contracts to risk violating the exchange trading requirement for futures or that they were being used to violate the open and competitive market of an order book. But there has been an evolution in the CFTC’s view in recent years and sometimes it’s hard to fathom why it now looks suspiciously at products the market has brought forth in order to make the transaction process less expensive and more useful to hedgers,” she adds.
Once EFS and contingent EFS were allowed to trade, the market for OTC energy swaps quickly revived – end-users were reassured that they would now face the Nymex clearing house on their trades.
Such was the resilience of the EFS product and the faith of legislators in it that as politicians began designing the biggest overhaul of US financial markets in 80 years following the financial crisis, none of the competing legislative drafts that would ultimately constitute the Dodd-Frank Act sought to alter the way EFS markets operated.
“There were millions of transactions of this nature executed every year from 2002 onward and the CFTC knew all about it. The exhaustive revisions of the Commodity Exchange Act made by Congress after 2008 said nothing about these products – good, bad or otherwise. In fact, the philosophy underlying Dodd-Frank is perfectly consistent with these transactions: we are turning OTC risk into a cleared, regulated futures position, subject to the CFTC’s reporting requirements and DCM position limits,” says one derivatives lawyer.
The CFTC initially shared that confidence, but it sought to place some federal strictures on transactions that were subject only to a DCM’s internal regulations. In a proposed rule published in the Federal Register on July 1, 2004, the commission noted that: “The CFMA specifically expanded the types of transactions that could lawfully be executed off the centralised market… permitting DCMs to establish trading rules that authorise the exchange of futures for swaps.” Among other adjustments, the proposal sought to clarify what constituted a bona fide EFS, but a final rule did not materialise.
The issue was resurrected four years later in another proposed rule, dated September 18, 2008, in which the CFTC sought “to make clear that transitory EFPs are permissible when each part of the transaction—the EFP itself and the related cash transaction – is a stand-alone, bona fide transaction. As with an EFP, a primary indicator of a bona fide cash transaction is the actual transfer of ownership of the cash commodity or position.”
This 2008 proposal again tried to place some federal parameters around what constitutes a bona fide EFS, but once again the proposals were never codified in a final rule.
When the CFTC published proposed core principles for DCMs under the auspices of the Dodd-Frank Act on December 22, 2010, it took on EFRP trades for a third time. On this occasion, however, the attitude of the commission – now under chairman Gary Gensler – had hardened and the rule included a blanket prohibition.
The proposed rule “prohibits DCMs from permitting a contingent exchange of derivative for a related position transaction where the exchange of derivative for the related position is contingent upon an offsetting transaction”.
This provision would have banned outright the transitory EFS trade, lawyers say, given that the transaction involves the conditional termination of two offsetting OTC swap positions. The support the commission had expressed for transitory EFS trades in their infancy was gone, and had been replaced with an intent to forbid the trading of such products altogether.
When the final DCM rules were released 18 months later in June 2012, however, the proposals relating to contingent EFS were absent, replaced only with the assurance that “the commission plans and expects to take up the proposed rules under core principle 9 when it considers the final swap execution facility (Sef) rule-making. The additional time will allow the commission to consider the available alternatives for contracts that may not comply with the proposed centralised market trading requirement including... exchange of derivatives for relates [sic] position transactions.”
The final Sef rules appeared in May 2013 without touching on EFRPs and observers are in no doubt as to why, for a third time in nine years, the CFTC has been unable to finalise rules overhauling the regulation of EFS products.
“The CFTC simply does not have the three votes it needs to pass the measure. It tried to ban contingent EFS transactions back in 2010 and could not get the votes to have it adopted as a final rule,” says one lawyer with knowledge of the matter.
“After a failed proposal to ban the product, the CFTC has decided this year to engage in some kind of enquiry to see whether the first leg of the transaction is valid and is a bona fide swap, despite the commission’s full knowledge that the trade is null and void if the futures leg is not accepted for clearing. Why the agency is engaging in this enquiry is not apparent to anybody, nor is what it hopes to accomplish,” he adds.
The CFTC declined to comment for this article. A spokesperson said the agency could not even confirm the existence of the special call notices. Similarly, dealers including Goldman Sachs, Morgan Stanley, JP Morgan, Bank of America Merrill Lynch and Citi all refused to comment or to confirm receipt of a special call.
Faced with an official wall of silence, it is impossible to know what is motivating the CFTC – and whether, as observers suggest, the agency is responding to its repeated failures to rein in the market, by launching a different kind of campaign. Whatever the driver, the commission’s actions have attracted some fierce criticism.
“Why these products are now on the CFTC radar as a possible enforcement matter is something I find bewildering. It’s frustrating that there is some suggestion from the commission staff that they now consider contingent EFSs involving energy commodities as perhaps constituting illegal trading activity. I struggle to find what the basis would be for an argument that says the futures leg of a contingent EFS trade is somehow illegal when it is traded subject to the rules of regulated futures exchange,” says Kathryn Trkla, a partner in the securities, commodities and exchange regulation practice at law firm Foley & Lardner in Chicago.
If, as commonly understood, the special calls have been sent out to determine whether EFRP products are being used to evade the requirement that futures must be transacted on a DCM, legal experts claim the CFTC will have a tough time making its case.
It may prove especially taxing given the regulator’s support for EFRP products when they were first developed and in light of the fact that the regulations governing the trading of futures survived Dodd-Frank largely unchanged. The latter fact denies the commission grounds to use a statutory alteration as justification for its U-turn, attorneys say.
“I have not heard the CFTC articulate what basis it could have for concluding that EFS transactions involving energy commodities – which it has permitted for ten years under exchange rules – should now be seen as improper. The swap leg of a contingent EFS trade may now be subject to CFTC swap regulation, but that has no bearing on whether the futures leg of the transaction is valid and has taken place in accordance with an exchange’s rules,” says Trkla at Foley & Lardner.
Fellow attorneys agree, arguing the ongoing regulatory investigation is essentially a solution in search of a problem. “If the CFTC’s theory is that EFS trades are illegal futures contracts disguised as swaps, I simply don’t think it will stand up as a legal argument. This is a misguided effort, expending enforcement resources to investigate activities that the commission has known about and allowed to continue for 10 years, during which time EFRPs have been very successful in moving unregulated OTC products into the regulated futures space. It’s mindboggling that they feel the need to investigate it,” says a lawyer specialising in futures markets.
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