Monetary Realism

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Futures vs. Swaps vs. Clearinghouses – on live TV!

I don’t know who had the idea to actually put this red hot topic on the air, but it made it! I was on Huffington Post Live yesterday talking about how the futures markets are taking trading volume away from the swaps market, and why this is good.

The segment turned out pretty well. There are a few points about futures vs. swaps which “everyone” should know:

1. Clearinghouse systems are inherently safer than bi-lateral agreement based systems.

2. Futures are well (and largely properly) regulated

3. Futures markets are probably the fairest markets in the world.

4. Modern clearing houses have fantastic risk management (despite what the swaps guy says in this video)

5. Swaps have been practicing regulatory arbitrage against the futures markets for several decades.

6. Credit Default Swaps are far more risky than Interest Rate Swaps. Interest rates swaps are not all that risky. Credit default swaps are like options on corporate debt.

7. Futures markets have reportable positions. This means once your total position gets large, you must report this to the regulators. Additionally, there are typically position limits as well. These two rules would have prevented AIG from putting on so many positions in one direction.

This could actually be an entire series of blog posts, but I’ve been really short on time.

On a day to day basis, it does not matter to the wider economy if these transactions take place on an exchange or in the OTC market. The macro effects of this discussion are not large, except when the system is near failure or fails.

The swaps market is at a huge disadvantage in the case of a near system failure. There is a clear and predetermined failure plan within a clearinghouse structure. The clearinghouse structure has massive transparency compared to the swaps market, and it’s quickly known who is going to take losses, and how large those losses are going to be.

But even more importantly, the rest of the market is priced. Futures markets get priced everyday, and the gains and losses are debited/credited to accounts on a daily basis. There isn’t a question who is holding radioactive bad contracts, or who is hiding losses, because these show up immediately.

In the swaps market failure, there can be weeks or days of sheer panic where nobody knows who is taking losses. Then at the end, some bankers get together in a back room with the feds and make a deal with the feds for a bailout.

The clearinghouse structure is simply much more transparent on every important point when the system is near failure.



Expert in business development, product development, and direct marketing. Developed strategic sales plans, product innovations, and business plans for multiple companies. Conceived the patent pending Spot Equivalent Futures (SEF) mechanism, which allows true replication of spot and swap like products in the futures space.

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7 Responses

  1. jt26 says

    Interesting stuff. I liked your mention of burgers … it was on my mind as well in a comment on JKH’s post … must be some weird behavoural psychology remnant from the Superbowl … :-) ( BTW middlemen tend to like opaque markets because they can capture more spread; users prefer transparent markets because they are cheaper. Regulators turn a blind eye until something blows up. The question is why haven’t users driven for more transparency over the years?

    • Michael Sankowski says

      The swaps market preys on the fact the contracts are for set tenors instead of fixed expiration dates. This is the major difference between futures and swaps, and the main reason I hate, hate, hate the current structure of swaps.

      Futures contracts have specific settlement dates, while swaps contracts are for x days, month, or years in the future from the trade date. What this does is create a market where the dealers have a huge and what I consider to be unfair advantage. Not many people can afford to create a desk where which holds inventory which is spread across this much time- only the dealers can do this. Futures contracts have set expiration dates and net out against each other. So purchasing a future and then selling it gets you zero exposure. But with swaps, every new day brings a new contract into play, across all the different tenors.

      This is particularly acute in the CDS market. The CDS market is a market which isn’t about exchanging cash flows. It’s a pure derivative contract. The cash flows on the contract are entirely secondary to the idea of the “bet” behind the contract. These contracts could and should be standardized with pre-set expiration dates and standard spreads over Libor.

      CDS contracts are essentially the liquid way to trade corporate debt. These things should be traded on an exchange, just like the equity markets are traded on an exchange.

      But the dealers did not do that at all.

      Also, the people that own the ICE clearinghouse are exactly who you would expect. Goldie, JPM, ect. They were actually forced to divest much of the ownership of this clearing house by the feds because of the concentration of who owned it.

      I was a spectator at all of this at the time, with front row seats to the entire process of how the Clearing Corporation became ICE Clear. The CDS guys were fighting it tooth and nail the entire time, and they are still fighting it. They know the standardization will take away their spreads, and they are actually moving into creating more complex products which are not easily put into clearinghouses so they can retain/increase their spreads.

  2. Michael Sankowski says

    I guess it is technically a VAR function, because they call it one in their literature. But its not the VAR the bond desks use at all.

    I am guessing the reason they use a 5 day VAR for the CDS is because the single name CDS aren’t very frequently quoted, and the bank desks were not very good at updating the daily risk in the past.

    The clearing house does not have that problem as they have a non-excel spreadsheet based system. 😉 so they can use real risk measurement.

    Also, 5 day VAR isn’t 5 times as large. It should be the 1 day VAR times the square root of 5, if they are using the same measurement period.

    My experience with SPAN is pretty high, and I found it to be very good at determining valid levels of risk.

    Still, there is a massive problem in the CDS market, because the prices/rates for corporate debt are not traded frequently enough. This means the input prices for the model aren’t always very accurate. It’s a big problem in the corporate debt markets with lesser traded names, and even major names can have parts of their curve which do not update prices for days at a time.

    it’s truly a huge problem.

    • beowulf says

      “evade SEC regulations on trading debt by being derivatives.”

      Who regulates them post Dodd-Frank, the CFTC? The swaps are still cleared through DTCC (a Federal Reserve member), no? If anyone at the Fed cared, they could push swaps onto exchanges by imposing onerous regulations or transaction fees. But then I’m a believer in regulatory deus ex machina. :o)

    • JKH says

      oh, it was VAR and not BAR

      I should have known



      yeah, the old square root of time

      heterogeneity in the financial swaps is the big obstacle, no?

      interesting if they’re making progress in standardizing them

  3. Michael Sankowski says

    The VAR stuff is totally and completely wrong. I didn’t want to slam it in the post, or get crazy during the segment, but futures clearinghouses do not use VAR. The margining is almost certainly done through SPAN (or something very close to SPAN) which uses the 99.5% confidence interval for the last 90 days if I am not mistaken.

    The margins are much cheaper when cleared as far as I can tell, at least according to this CME paper on deliverable swaps.

    Still,the guy defending swaps on the show runs a swaps execution platform, and I found him to be very smart, but very deceptive in his approach. He’s complaining about regulatory arbitrage, when much of the physical swaps market (think gold, oil, gasoline, nat gas) is doing regulatory arb right now. Financial swaps like CDS were originally designed to make them difficult to standardize, and only after 2009 have they started to standardize the terms.

    CDS should be on an exchange. They are trading the debt of companies, just like equity markets trade the equity of companies. They evade SEC regulations on trading debt by being derivatives. For the swaps market to complain about regulatory arbitrage is as close to a definition of chutzpah as I can imagine in the financial industry.

  4. JKH says

    Well done … and excellent summary

    Is that ‘1 day bar; 5 day bar’ stuff right?

    Sounds questionable – is there any confusion there between risk measurement versus margining frequency?

    Who’s imposing that 5 day standard, whatever it is?

    Do you happen to know how deep Basle drills down to capital requirements for swaps and futures?

    Just wondering if the 1/5 thing is related to that directly or indirectly.