In an address before the Managed Funds Association, Commodity Futures Trading Commission Chairman Gary Gensler laid out the basics of two key areas of the regulatory reform plan President Obama announced last week and brought back an issue sure to stir controversy.
Gensler focused on over-the-counter derivatives and hedge funds. He said “this new regime should govern 100% of OTC derivatives no matter who is trading them or what type of derivative is traded, standardized or customized. That includes interest rate swaps, currency swaps, commodity swaps, equity swaps, credit default swaps [and those that are unforeseen].”
He stated that there should be a regime to regulate dealers of swaps and a regime for market functions. He also stated, “we must mandate the use of central clearing and exchange venues for all standardized derivatives.”
He stated three essential feature for OTC central clearinghouses that touched on one of the most controversial issues in the industry— fungibility. Gensler said governance arrangements should be transparent and incorporate a broad range of viewpoints; central counterparties should be required to have fair and open access criteria; and “in order to promote clearing and achieve market efficiency through competition, OTC derivatives should be fungible and able to be transferred between one exchange or electronic trading system to another.”
Gensler did not elaborate further on what OTC products would be fungible but it has long been a bone of contention between established exchanges and certain clearing members.
When the Commodity Futures Modernization Act of 2000 was passed, the Futures Industry Association led by the large investment banks asked the CFTC to examine provisions creating a separate registration for clearing organizations to see if it would allow future commission merchants (FCMs) to select the clearinghouse they place their margin capital in. In addition to “common clearing” the FIA asked the CFTC to examine the idea of fungibility: that is being able to offset futures contracts with identical specifications that are traded at separate exchanges. At the time Brokertec Futures Exchange, which was owned by many of the same investment banks represented by FIA, had recently listed a suite of fixed income futures with the same specifications as those traded at the Chicago Board of Trade. The flashpoint of the battle occurred at an August 2002 CFTC roundtable where both sides argued their cases. FIA President John Damgard stated at the time, “By keeping their clearing operations closed and proprietary and their products non-fungible, [exchanges] make it more difficult for another exchange to compete.”
Jim NcNulty, CEO of the Chicago Mercantile Exchange (CME) at the time countered, “The proponents of fungibility and common clearing seek to internalize their dealings to take the markets upstairs [and] exploit the profits of the bid/ask spread.” He added that such a move would kill transparency and innovation.
The CFTC ended up siding with the exchanges as fungible futures were not adopted and FCMs were not allowed to shop for separate clearinghouses to park their margin capital. The controversy was the spark that led to the rift between the CBOT and the Chicago Board of Trade Clearing Corporation (the independent clearinghouse that cleared all of CBOT contracts) and led the CBOT to create the Common Clearing Link with the CME.
While Gensler was referring specifically to cleared OTC contracts, established exchanges have fought any recommendation of fungible futures contracts, seeing it as the camel’s nose under the tent. A large amount of OTC trading involves cash fixed income products that are traded against the CME Group’s Treasury complex. If the cash component becomes fungible, an argument could be made for the futures to be as well.
Fungibility would improve the chances for a new exchange, such as ELX and their suite of fixed income futures that is set to launch this summer, to successfully build traction as traders could lean on the pools of liquidity in the established contracts.
CME Group was busy Wednesday responding to the Permanent Subcommittee on Investigations’ report on the performance of the CBOT Wheat futures contract but it looks like the fungibility battle may be teed up again for another round. Stay tuned.
Tags: Fungibility
[...] While he joked about fungibility, that has never been a laughing matter for Futures exchanges and as apposed to the last time the industry was discussing the issue—however you define it—there appears to be support from the regulatory community. [...]