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April 23, 2013

Wall Street is at it all over again

On Tuesday, April 16, Bloomberg, the financial news and data giant, filed a lawsuit against the Commodity Futures Trading Commission, one of the most important regulatory bodies overseeing U.S. financial markets. The lawsuit was about new rules governing financial instruments known as swaps—rules, which, according to Bloomberg, will push investors toward new hybrid financial products that “have less regulatory requirements, less transparency, but pose much higher investor risk” than swaps. These adverse and “presumably unintended” consequences, the legal statement goes on to say, are a good enough reason to halt the rule’s implementation.

There’s a feeling lately among long-time Wall Street observers that U.S. financial regulators seeking to tame the industry’s excesses are engaged in a cat-and-mouse chase in which the mouse is often one step ahead.

In the five years since the financial crisis bankrupted Lehman Brothers and precipitated the federal bailout of Wall Street, the stock market has rebounded to all-time highs and major Wall Street firms ended 2012 with the second best earnings reports on record. Behind these successes is the industry’s ability to swiftly shift business strategies to adapt to new regulation, but also exploit loopholes and accidental gaps between rules from different markets and jurisdictions in unexpected ways. The raft of financial regulation inaugurated by President Barack Obama’s 2010 Dodd-Frank reform act has thwarted some risky practices—but also created opportunities to try out new ones. As each new plank of the reform comes into effect, a recurring theme has been that of unexpected consequences.

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This is where swap futures come in. They’re futures contracts that come in two varieties, so far: one type promises the purchase or sale of a swap, (rather than gas or some other product), at an agreed price and time in the future — the value of these swaps futures corresponds to the expected value of that swap at the time of delivery. Most buyers of these products will be purchasing them with the intention of selling them onward in turn, rather than taking ownership of the swap itself, according to Sean Tully, managing director of interest rate products for CME Group. The end result is a product tied to the swaps market that is much cheaper and quicker to trade. The second kind is Intercontinental Exchange’s energy swap futures, which are essentially energy swaps tweaked to be future contracts.

But if swaps and swap futures are so similar, why are regulators only focusing on one of them? David Frenk, director of research for Washington D.C. consumer advocacy firm Better Markets, sees the move from swaps into swap futures as a potentially dangerous development. “Futures exchanges like to boast about their track record of stability, compared to other exchanges, especially during the financial crisis,” he says. However, he adds, “the swaps market is many times larger than the futures market, so a move from swaps into swap futures could grow the futures market to a gargantuan scale.” A larger futures market might invite riskier behaviour in pursuit of larger profits, and Frenk worries the exchanges may not be up to the challenge of maintaining stability in a much bigger and more dynamic market.”

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Read full Maclean’s article here

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