Stirring the Pits

By Kathleen Hoffelder


A little-known CFTC proposal, the 85% rule, is causing a stir in the futures pits. Though it sounds more like some drink concoction, if the CFTC has its way it will be the latest manuever to keep OTC block trading in check. The rule places volume restrictions on products, which opponents say could halt new-product development altogether. Kathleen Hoffelder reports.

Its Core Principles and Other Requirements for Designated Contract Markets (DCMs) were first proposed by the Commodity Futures Trading Commission last March but market participants criticised the notice of proposed rule-making so much that the CFTC subsequently issued a formal data release to accompany the ruling. The commission also extended its deadline for comments on the rule to last week from the original February deadline.

As it stands, the rule states that any product traded on a DCM that does not obtain 85% of its volume within a 12-month period (plus an additional grace period) on a central limit order book, and instead is traded more heavily over-the-counter, would have to be delisted and offered to a swap execution facility (SEF).

But the initiative goes beyond just percentages. It is widely seen as an attempt by the CFTC to strike a balance between block trades, or those large-size trades that often take place off-exchange, and regular sized trades. Since the CFTC has long been an opponent of block trading that takes place in the over-the-counter market, it does not favour having more than 15% of a product’s volume traded off-exchange, where it believes price discovery is not reliable.   

The subject is a touchy one for both OTC and exchange participants. Had the ruling already been in place, it would have excluded some well-established flagship products that trade on the CME Group today. Many of its foreign exchange products and even S&P 500 futures, for example, would not have met that stringent 85% requirement in the first two years of their existence.

Indeed, several products cleared on CME’s clearing house ClearPort today also do not make the cut. OTC ethanol forward month swaps, corn calendar swaps, and euro/Turkish lira futures, for example, are mostly traded in the OTC market.

The CFTC study also only used data from May 3, 2010 to July 30, 2010, which many participants say is too small a sample to make an appropriate judgement, particularly in agricultural derivatives, which tend to have seasonal impacts.

“There’s no real connection between the 85% threshold and public protection,” said Neal Wolkoff, CEO of ELX Futures. “We don’t think we should be hampered in trying to compete because we have this clock ticking, which will be a disincentive to clients.”

CME Group’s Tim Doar would agree with that assessment. “Name a product that has achieved that kind of volume on a central limit order book as opposed to off-exchange,” said Doar, who is a managing director in risk management at CME Group, speaking during a Futures Industry Association conference earlier this month.  

New derivative products, at least in the futures markets, tend to build up open interest in the OTC market before being listed on exchanges.

“If we were to launch a new product, there are a lot of market participants that would be very concerned that we only have two years to build liquidity. If we get trades that are put on by block trading or EFPs [off-market transactions that exchange OTC derivatives for exchange traded derivatives] and two years passes and we don’t have 85% of it being done on screens, then it will move to another platform and the nature of that market will change,” said Wolkoff.

“We don’t think we should be in that position of having to suffer that uncertainty or tell clients that they may have to suffer that uncertainty,” he added. Under the proposed rule, related products could very easily be split up to the detriment of clients. If a futures contract remained on a DCM, a related options product could very well be delisted to an SEF.

Some products have already felt the CFTC’s wrath in this area. “We have products at CFTC up for approval for years on an OTC basis but we’ve had to pull back since they look like a futures product … Now it looks like there’s a new benchmark to determine what is a futures product. It’s now based on this ratio of what can be executed,” said Thomas Hammond, president chief operating officer at ICE Clear US, a subsidiary of The IntercontinentalExchange, also at the FIA conference. Still, the CFTC could have a point in targeting block trades that have been misreported in the OTC markets in the past, according to some market participants. “Regulators are appropriately being prescriptive here to ensure there is no chicanery that can occur,” said one head trader at a SEF.

Tensions are divided on the issue since the market wants to know what the last trade was in a given market, but market-makers need to be given sufficient time to initiate block trades and trade out of block positions. If a market-maker reports a large trade in real-time, however, the market can move against him.

“The market needs to be protected from any kind of game playing that may ensue where people attempt to move regular size trades off-screen under the guise of block trading,” said Jamie Cawley, CEO at Javelin Capital Markets.  

Exchanges could also be put into the position of opening up a SEF, if they did not already have one, if products began to migrate out of a DCM.

For sure, the 85%-15% rule is pitting DCMs against SEFs, though SEFs would not typically have a problem accepting non-swap products into their models. One participant said the proposed rule gives “short shrift” to the traditional exchanges and the DCM model in favour of SEFs.

Regardless of how the percentages or revised trading timeframe may play out in the final CFTC ruling, the use of DCMs and SEFs is here to stay, albeit not in the form everyone might want.