Among the many (many) details contained within the mammoth Dodd-Frank financial reform bill is a set of rules that will change what derivative swaps can take place off-exchange. In other words, there will be stricter limits on off-exchange swaps, resulting in more of these trades taking place within established exchanges – the whole process is sometimes called the “futurization” of swaps.
The goal of this reform is to bring more regulatory oversight to the $300 trillion swaps market – trading on exchanges is supposed to provide more transparency and force a bigger slice of the derivative trading market to abide by existing exchange rules. But this transition is introducing another wrinkle to the markets, as well: which exchanges are going to score all this new business? The Wall Street Journal explains what’s at stake:
Some traders believe a harmonization between the block proposals in swaps and futures, and the margin treatment of both, hold the keys to determining which venues will see the most derivatives activity in the wake of the 2010 Dodd Frank law.
That law mandated that a large chunk of the $300 trillion U.S. swaps market be traded openly for the first time, either on exchanges or alternatives called “swap execution facilities.”
If the block thresholds and margin requirements are similar for futures and swaps, then market participants are more likely to pick platforms based on their individual merits and their needs. If futures markets have more favorable blocks and lower margins, exchanges are more likely to win a greater share of activity because the rules would incentivize trading in futures over swaps, traders say.
Futures trading volumes have dropped off over the few last years, so the competition is likely to be fierce. And if these regulatory changes end up making futures markets more attractive, the CME Group could be looking at quite a boost. This wouldn’t necessary change the dynamic too much for managed futures – more traders won’t necessarily change the trends – but increased volume could change the way larger firms approach position sizing.
We’ve talked in the past about how most of the biggest CTAs are “stuck” trading only the most liquid of futures markets – contracts like S&P 500 futures – because they’re too big to make trades in smaller markets (like coffee or orange juice) without moving those markets with their trades. More market participants and higher volume might make it feasible for larger CTAs to move into some of the currently more thinly traded markets.
This is all still very hypothetical at this point. But nevertheless, higher futures volumes is something that we (and undoubtedly the CME) are quietly rooting for.