A Swap By Any Other Name

ICE has created something of a kerfuffle with its announcement that it will convert its cleared energy swaps contracts to futures. Despite a lot of breathless reporting, there is less here than meets the eye.

ICE has merely relabeled its cleared energy swaps as futures in order to avoid burdening its customers with the costs that Frankendodd imposes on swaps. Futures and swaps are subject to different regulatory regimes. Firms with sufficiently large swap positions are considered swap dealers under Frankendodd, and must meet a variety of requirements that those not blessed with this designation can avoid: Holders of equivalent futures positions need not meet the same requirements. Swaps trades also involve additional reporting obligations not imposed on futures trades.

So what ICE will do, effective in January, is change the name of its contracts, thereby reducing the regulatory burden on its customers without changing their economic substance one iota. Note that these are cleared swaps, so the change doesn’t create a new clearing obligation on those trading them. The central counterparty for the futures will be the same as for the swaps: ICE Clear Europe. The contracts will have identical settlement terms. They will have identical cash flows. They will trade on the exact same ICE platform. The economic substance of every aspect of the old "swap" transaction and the new "futures" transaction remains the same, from execution to clearing to settlement. Nothing changes but the name.

And the regulatory burden.

Which points out the potential for absurd outcomes under Frankendodd. The CFTC has labored mightily to craft definitions of a swap and swap dealers and major swap market participants. Where one falls under these definitions matters a lot. Firms will endeavor to take measures that minimize the regulatory burden they face. ICE is basically picking the low-hanging fruit, and taking note of Congress’s morbid obsession with "OTC swaps" and idealization of futures by magically transforming the former into the latter, and thereby making life easier -- and cheaper -- for its clients.

The incentive to label or structure transactions to achieve the same economic outcome at lower regulatory cost will be quite strong in the Frankendodd era. This will initiate a regulatory dialectic in which regulators will attempt to adjust regulations in order to limit such attempts to escape regulatory burdens by relabeling or restructuring, the regulated will adjust to the adjustments, the regulators will adjust some more, and on and on. (Relabeling of derivatives contracts was employed in the 19th century to avoid legal restrictions. When Illinois banned options trading, traders bought and sold the same things, but started calling them privileges.)

The lawyers will rejoice.

Much of the reporting on the ICE move has been pretty far off base, such as this from the Wall Street Journal:

Derivatives exchange IntercontinentalExchange said it plans to overhaul trading in trillions of dollars of energy contracts starting in January, becoming the first exchange to take such a step ahead of new financial regulations. ICE is pushing trading of certain energy contracts onto its exchange, a move that would likely diminish the more opaque world of over-the-counter derivatives trading. The plan will likely appease lawmakers who have decried the lack of transparency in such portions of the financial markets. Many energy producers and users generally have preferred swaps contracts because each contract can be written up individually and to a company’s own specifications. That has enabled them to be more targeted in their hedging. Futures contracts, by contrast, are generally standard contracts covering the price of a specific energy grade to be delivered at a certain time.

Pretty much none of that is true. All of it suggests a change in the way these instruments are designed, traded, and cleared -- none of which is in fact changing. The contracts are already standardized, traded on an electronic platform, and cleared. This is not a movement of bespoke, uncleared, bilateral contracts onto an exchange.

Look: It’s long been known that the economic substance of swaps and futures are effectively identical, especially when the former are cleared. Changing the label -- heck, call them bananas -- doesn’t change the economics. If the CFTC had even less burdensome regulations for bananas, ICE would launch ICE Bananas.

Which illustrates that Frankendodd is quite often, and in many ways, truly bananas.