Department of Accounting and Finance

AG925 Derivatives and Treasury Management

Discuss the advantages and disadvantages

of the futurisation of swaps and the regulators’
drive to regulate the OTC markets with
regulatory initiatives such as MIFIR and MIFID II

Group 2

Amit Gumasta 201759331

Anastasios Lingis 201772279
Nikos Karakaisis 201794685
Sean Quinn 201764094
Moritz Meyer 201763498

Word count: 2039

Dr. Dimitris Andriosopoulos and Prof. Andrew Marshall

5th March 2018

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Swaps are defined by Aditya (2013) as a subgroup of derivatives which is an
agreement between two parties to exchange cash flows depending on the value of an
underlying asset. The cash flows are exchanged over a certain period of time
depending on various frequencies and specified conditions. Taylor (2013) states that
swaps are confidentially negotiated over the counter (OTC) deals. An OTC deal is a
customised instrument privately negotiated between two parties as the price is
determined directly between the two counterparties (Cuccia, 1997).

Economic growth, globalisation and technological advancements motivated the

expansion of OTC derivatives markets to make them the largest global market (BIS,
2017). At the same time, history shows that derivatives and OTC markets can lead to
the creation of economy-wide adverse events, as pointed out by IOSCO (2010). IMF
(2000) highlights that the hedge fund Long-Term Capital Management nearly
collapsed in 1998 due to derivatives’ inefficiencies which contributed towards building
instability and systemic financial problems. More recently, during the global financial
crisis of 2007 and 2008, OTC derivatives markets were a major factor that amplified
the global recession (Slahor, Majercakova and Bartekova, 2016). American
International Group (AIG) illustrates a common example where a significant
contributor to its failure was over exposure in derivative positions (Chander and Costa,
2010). AIG is a systemically important insurance firm, where the government’s
intervention was required to avoid the failure of AIG and the knock-on effects to the
wider economy.

Subsequently, in September 2009, a group of the twenty largest and most prominent
governments by economic scale concluded that significant regulatory changes were
required to mitigate similar events and restore the credibility and faith towards the
global financial markets (G20, 2009). Not surprisingly, it was agreed that fundamental
changes, such as further central clearing party (CCP) requirements, trade repository
reporting, and higher capital requirements for non-CCP cleared contracts, were
needed to be made in regard to regulating the OTC derivatives markets. We consider
it to be a significant step towards monitoring the OTC market. However, we
acknowledge the fact that there are benefits and costs of more regulation for the
economy and the resilience of the financial markets.

The most important factor that drove regulators to regulate the OTC markets is price
discovery. Shadab (2010) defines price discovery as the process when the market

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participants determine the actual value of a particular financial product. According to
the European Commission (2018), the financial crisis was heavily associated with
OTC markets. These markets had little transparency and therefore reduced price
discovery, so they were forced to amend regulations on OTC markets in order to
improve price discovery and achieve financial stability (Rosenberg and Massari,
2013). As a result, the European Parliament introduced Markets in Financial
Instruments Directive 2 (MiFID II) in April 2014 which would be implemented in
conjunction with Markets in Financial Instruments (MiFIR). They were aimed to expose
weaknesses in relation to how much information is shown on trading opportunities and
prices in financial instruments to market participants. One of the proposed rules of
MiFIR includes transparency measures in OTC markets for derivatives and finance
structured products so that price discovery is improved (Ferrarini and Saguato, 2013).
Lastly, IMF (2000) makes a comparison between the exchange market called the
Chicago Board of Trade and OTC market and concludes that the latter was an
unregulated market with no transparency. Consequently, these regulations were
meant to protect the investor and achieve efficient price discovery.

Another major inefficiency that arose from the use of the opaque OTC derivatives
markets is counter-party risk, which could lead to a quick loss of market confidence
(Rahman, 2015). In other words, the question arises whether or not the counter-party
will honour their commitment on the agreement that the two parties entered into. As
Acharya and Bisin (2010) state counter-party risk evaluation within the OTC markets
is a complex and difficult process due to limited information available. For example,
party A enters into a derivative contract with party B and before doing so, party A
carefully examines the likelihood of party B to deliver the contract obligations. If both
parties believe that the contract will be met by the counter-party then a deal is made.
However, this is a complex practice in the OTC markets. This is because entity B might
have other OTC derivatives exposures with many other OTC market entities that A is
not aware of. The interconnectedness of OTC participants is on a bilateral level and
participants other than the immediate dealers have very little information on it. As a
result, regulators wanted to increase the scope of OTC derivatives contracts that
should be centrally cleared to mitigate the counter-party risk within OTC derivatives
market. That was initially achieved by the introduction of earlier regulations and in a
later stage by MiFIR and MiFID II introducing the new organized trading facility which

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reduced counterparty and systemic risk (IOSCO, 2011; FCA, 2018). BIS (2014) states
the CCP would sit between the bilateral deal and the CCP would be the buyer to every
seller and the seller to every buyer. Ruffini and Steigerwald (2014) summarise that
limiting the counter-party risk was achieved by driving OTC derivatives contracts to be
cleared through a CCP or by imposing higher capital requirements on non-centrally
cleared OTC derivatives contracts, discouraging such activities.

Driven by these circumstances a series of regulations were enacted. For instance, in

2010, the Dodd-Frank legislation bill was signed in the United States after the financial
crisis (Skeel, 2010). The legislation was aimed to implement new regulatory structures
for both derivatives and institutions by managing the riskiness of contracts, issuing
strict clearing and margin requirements and provision of a tough insolvency framework
(Skeel, 2010). Concerning China, the Provisional Administrative Rules Governing
Derivatives of Financial Institutions was brought into force in 2007 serving as a
mechanism in monitoring derivatives activities and was last revised in 2011 (Hsiao,
2017). Furthermore, in India, regulatory initiatives on OTC derivatives were introduced
with centralised counterparties as the most dominant solution (Arora and Rathinam,
2010). Lastly, MiFID II and MiFIR were introduced by the European Union in 2018
(ESMA, 2017).

The cost intensive regulation measures have driven the market to futurise their swaps
as opposed to keeping them in the new and highly regulated OTC markets.
Regulations come with many advantages and disadvantages that differ between
market participants. It is evident that the recent attempt to regulate the OTC markets
motivated the futurisation of swaps. The high infrastructure costs incurred by market
participants to oblige with the new regulations, the uncertainty introduced within the
OTC markets and the lower margin requirements when dealing with futurised swaps
were some of the most significant factors that contributed towards this migration. As a
result, market participants leveraged new products that are traded as futures but
provide the advantages of swap transactions (Acworth, 2013). As Litan (2013) argues,
market participants utilise these products as a measure to mitigate risk. Futurisation
of swaps, as defined by Aditya (2013), is the process of standardising the terms of
delivery and settlement of an OTC swap contract such that this can be listed on an
exchange.

According to Aditya (2013), the use of futures enables market participants to decrease

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the nominal volume of their swaps and reduce regulatory burden. This allows swap
dealers and major swap participants to avoid registration with the commodity futures
trading commission who regulate the futures market. Hence, futurisation permits
participants to avoid the new swap market restrictions under certain circumstances.
Futurisation also allows investors to circumvent the issues posed by congested
regulation measures in over the counter markets as stated by Kaminsky (2013).
According to Aditya (2013), futures contracts are inherently transparent and easily
cleared while also keeping the risk profile associated with swaps. Futurisation also
provides safety to market participants in the public securities and futures markets by
helping the markets to maintain transparent and orderly conduct which enables the
investors to reduce their trading cost (Cuccia, 1997). However, some detractors
contend that the futures market is indeed non-transparent. According to Litan (2013),
futures prices are quoted in ten-minute segments which leaves plenty of time in
financial markets for arbitrage exploitation. The author argues that for investors
seeking to avoid regulation measures, futurising their swaps is beneficial to them but
would concentrate the number of investors seeking this regulatory arbitrage. Litan
(2013) also states that futures exchanges limit the size of block trades to the absolute
minimum. In doing so, almost all futurised swaps are not traded on an exchange order
book, which is almost completely transparent, and instead traded over the phone
without a record. This results in the very same pricing opaqueness that regulations
were supposed to combat in the swap market.

Another benefit of futurisation of swaps, as pointed out by Taylor (2013), is that futures
infrastructure is stable while new rules governing swap execution, clearing and
reporting remain unsettled and sometimes unclear. This is because new rules
regarding swaps will be challenged and exemptions will be sought by market
participants before the new infrastructure settles. Aditya (2013) argues that futures
exchanges are already established and fully functional and most firms already have
the ability to trade and process futures resulting in reduced regulatory uncertainty
surrounding futures which are cleared, and exchange-traded. Thus, futurisation helps
to remove barriers to entry in exchange markets while enabling market participants to
decide their clearing arrangements.

Additionally, futurised swaps benefit from lower margin requirements than their OTC
counterparts. Futurised swaps are margin based on one-day value at risk, whereas

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OTC swaps are margined on a five-day value at risk, as stated by Park and Abruzzo
(2016). Trading futures are less costly compared to swaps (Deloitte, 2016). This is
because swap counterparties face additional costs as dealers will likely pass
increased registration and compliance costs to end users in the form of larger spreads
or higher transaction fees (Taylor, 2013).

However, some argue that the futurisation of swaps is disadvantageous to the investor
and the market as a whole. Since there has been a mass migration to the futures
market since the implementation of Dodd-Frank, many have studied the
consequences of such an unprecedented event. There is plenty of evidence that
suggests futurised swaps can be advantageous, but our research suggests that this
is not absolute, and there are various disadvantages.

To begin, futurised swaps lack the option of optimal customisation of OTC-traded

swaps. Aditya (2013) argues that since futures contracts are standardised, there may
not be a futures contract available for the investor’s desired hedge. Moreover,
differences in contract duration will diminish an investor’s selection of hedges.
Additionally, corporate hedgers need an exact match on interest rate exposure for
these contracts in order to qualify for hedge accounting because derivatives must
offset the interest rate risk (Acworth, 2013). Furthermore, the restriction on block trade
orders leads to a lack of customisation in futurised swaps and proves that they are not
suitable for large trades. Their utilisation of direct cash payment methods also limits
the scope of delivery of such trades (Taylor, 2013).

Lastly, another disadvantage is that futures contracts are vulnerable to high basis risk.
Taylor (2013) defines basis risk as the risk that the value of a futures contract will not
move in synchronisation with that of the underlying hedged exposure. The author
states that due to their standardised nature, attempts to futurise unique swap exposure
will increase the overall level of basis risk. This results in an imperfect correlation
between the hedge and the underlying liability and can cause significant losses if the
contract moves in the opposite direction (Aditya, 2013). In many cases, the actual risk
hedged on futurised swaps will differ from the exposure risk because of the application
of multiple financial instruments to mitigate the risk factor (PLC Finance, 2013). This
will encourage complex hedging strategies and transactions that may lead to
disqualification from hedge accounting practices.

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In conclusion, futurised swaps offer market participants the ability to trade swaps in a
less uncertain and less costly futures market. This innovation appears to fill several
needs in the newly regulated OTC market. In our opinion, the introduction of
regulations was essential to achieve transparency which leads to mitigation of risk and
other efficiencies which would be otherwise absent in the unregulated market.

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