Friday, September 17, 2010

Regulation on the Move: the Swaps Market

Glimpses of the regulatory process are starting to hit the news. Gary Gensler, Chairman of the Commodity Futures Trading Commission offered some insight into the process as he spoke of the evolving discussions surrounding the swaps market.

It is estimated that the swap market has over $600 trillion in contracts outstanding. (The Gross Domestic Product of the United States, in current dollars, is a little less than $15 trillion.) There are now 16 regulated futures exchanges that could handle swap transactions. Gensler expects that there may be 20 to 30 more organizations that will register as Swap-execution facilities (SEFs), organizations that would match buyers and sellers and provide more transparent pricing and information to the world.

One of the known unknowns about the swaps market is the volume of trades that will take place. Currently, swaps are created privately and are traded privately. The trading volume is not very substantial given the dollar-volume of the swaps market.

The chief executive of the International Swaps and Derivatives Association (ISDA) states that fewer than 2,000 standardized swaps, on average, are traded daily. The most active, the 10-year dollar swaps, only trade about 200 times a day.

One might expect that as this market develops and more transparency and openness come to the market that volumes will increase. This is the experience of other derivative markets as they have moved to more formal and standardized formats.

Gensler guesses that maybe up to 200 organizations may want to become “swap dealers.” These organizations would have to “register” under the new setup and meet regulatory qualifications for being classified as such.

Of interest is the fact that of these 200 or so organizations that might move in this direction about 75 banks could be considered to be swap dealers. This total, Gensler stated, consists of 25 global banks, 25 non-US banks that do some trading in the United States, and a further 25 US banks that are not global in scope.

“The rules could require these 75 banks to set up separate entities, with their own capital, that would be registered to trade derivatives including commodity, equity, and some credit default swaps.” (See

The new rules and regulations are supposed to be in place by July 2011. Gensler told CNBC that he has enough staff to develop the rules. The problem is that he will need at least 400 more employees to enforce them. (See

It is very, very difficult to write new rules and regulations for financial markets that were previously just “over-the-counter” markets. Even going back historically to the “standardization” of relatively simple instruments, like interest rate futures and so forth, shows how difficult it is to capture all the nuances and quirks that relate to a specific type.

The new standardized, formal markets will be forthcoming. They will be heavily used and trading volume will increase substantially as information becomes more public.

Perhaps the ultimate, bottom line conclusion to the developments described above is that the swap market will grow and prosper, including the sector relating to credit default swaps. The hysteria connected with the financial crisis has subsided and financial innovation continues on. The populist outcry against the greedy bastards that developed the derivatives industry is fading into the shadows.

So, financial innovation is alive and well. It is impossible to know what form it will take next.

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