Last Friday, U.S. District Judge Beryl Howell handed down a second opinion in the Commodity Future Trading Commission's favor as the agency spars with the industry over its Dodd-Frank rules. (Judge Howell's first opinion was a ruling last December against the Investment Company Institute and the U.S. Chamber of Commerce, which are challenging a CFTC rule governing mutual funds.) Last week, she ruled against Bloomberg in its challenge of a CFTC rule that Bloomberg contends will affect the business prospects of its swap execution facility, an electronic trading platform for swaps. The Bloomberg case is a temporary victory for the CFTC, but it's not necessarily a long-term win for the agency as it remakes the swaps markets under Dodd-Frank.
The CFTC rule at issue affects the margin requirements that derivatives clearing organizations (clearinghouses) impose on the swaps, which can trade on swap execution facilities such as Bloomberg's. Bloomberg argued that the rule forces these clearinghouses to treat products differently based on whether they are swaps or futures, regardless of whether the products' risk profiles justify the disparate treatment. The rule could give futures--which trade on exchanges--a leg up over swaps.
The court concluded that Bloomberg was complaining of a "theorized injury" and had failed to show that clearinghouses would actually determine their margin requirements based on CFTC's rules rather than their own risk assessments of the products. The court also faulted Bloomberg for its "red herring" contention that harm could deepen with the arrival of the CFTC's deadline for many entities to begin clearing swaps this week. As the week draws to a close, the effect of that deadline remains unclear. It is clear that many market participants are simply not equipped to clear swaps, which means that--regardless of margin requirements--they will not be able to use swaps or swap execution facilities.
Many point to swap execution facilities as a promising aspect of Dodd-Frank. They hope that these trading platforms will erode swap dealers' leverage by offering their customers an alternative way of entering into swap transactions. In addition, swap execution facilities embody a departure from the traditional futures model in which a futures contract trades only on the exchange that lists it and that exchange is linked with a single clearinghouse. By contrast, market participants will be able to choose where to execute their swaps transactions and the choice of swap execution facility will not determine where a swap will be cleared.
The prospects for innovation and competition in this area, seem to turn largely on how Dodd-Frank was drafted--drafting that included many technical and substantive errors--and the sometimes arbitrary choices that the CFTC makes in regulating the market. The fact that a judge has blessed those choices does not change the perversity of a market's development being driven by legislative and regulatory whim.