(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON Aug 6 IntercontinentalExchange (ICE)
last week surprised the derivatives world by announcing that all
its over-the-counter cleared energy swaps will be converted to
futures contracts from January 2013.
Most market participants had expected these products to be
brought within the framework of futures regulation after new
rules implementing the Dodd-Frank Act reversed the previous
advantages for OTC swap contracts compared with exchange-traded
But few expected it to happen so quickly. It is a marked
victory for governments seeking to ensure that all standardised
products will be traded on exchanges or electronic trading
platforms and fulfils one of the promises made by G20 leaders at
their summit in September 2009.
"Increasing the proportion of the (derivatives) market
traded on organised platforms is important so as to improve
transparency, mitigate systemic risk and protect against market
abuse," according to the OTC Derivatives Working Group of the
Financial Stability Board.
Cleared OTC swaps were already traded on an electronic
platform and subject to margining rules. But the transition to
futures status should boost transparency and bring them into a
clearer regulatory framework.
ICE announced that OTC cleared swaps for North American
natural gas, electric power, environmental products and natural
gas liquids (NGLs) will be listed as futures on ICE Futures U.S.
Cleared oil products, freight and iron ore swaps will be listed
as futures on ICE Futures Europe in London.
The conversion is subject to approval by futures regulators
in the United States and the United Kingdom.
"We anticipate a seamless transition that will largely
preserve existing methods of transacting in ICE's markets," ICE
President Chuck Vice promised in a press statement on July 30.
FORWARDS, FUTURES, SWAPS
In the United States, futures contracts have attracted
stricter scrutiny and tougher regulation than other contracts
since the Grain Futures Act of 1922 (and in some individual
states the nineteenth century). Most other countries have
followed suit, creating a distinct and tougher regulatory
environment for futures dealing.
But rules covering "contracts for future delivery" have
always excluded "any sale of any cash commodity for deferred
shipment or delivery", creating a strong incentive to ensure
agreements are classified and treated favourably as forward
delivery contracts rather than futures ones (7 USC 1(a)(17)).
The U.S. Commodity Futures Trading Commission (CFTC), which
has authority to regulate futures but not physical forward
transactions, has spent decades struggling to work out a way to
distinguish clearly between the two, generating an enormous body
Under Dodd-Frank, the CFTC's jurisdiction has now been
extended to cover swaps, but again the term "swap" has been
defined for the purpose of regulation to exclude "any sale of a
nonfinancial commodity or security for deferred shipment or
delivery, so long as the transaction is intended to be
physically settled", mirroring the distinction between futures
and forwards. (7 USC 1(a)(47)(B)(ii))
The CFTC has promised to extend its current practice of
distinguishing between futures and forwards into the swaps
"Under the Commodity Exchange Act, the CFTC does not
regulate forward contracts. Over the decades, there have been a
series of orders, interpretations and cases that market
participants have come to rely upon regarding the exception from
futures regulation for forwards and forwards with embedded
options," CFTC Chairman Gary Gensler told a public meeting of
the commission last month.
"Consistent with that history ... the Commission is
interpreting (the exclusion for physically settled swap
contracts) in a manner that is consistent with Commission
precedent and, in response to commenters, is providing increased
clarity on the forward exclusion from futures regulation," he
"The final release provides guidance regarding forwards with
embedded volumetric options, like those used within the
electricity markets, and is requesting comment on this
1991 BRENT INTERPRETATION
The CFTC has already had to confront the distinction between
futures and forwards after a U.S. District Court ruling in 1990
that forward transactions involving crude oil from the Brent oil
market were in fact futures contracts that needed to be traded
on a contract market regulated by the CFTC.
"Many oil traders began shifting their operations offshore,
and foreign traders refused to deal with United States entities.
Brent oil market volume declined significantly," according to
Professor Jerry Markham's magisterial "Financial History of the
In 1991, "the CFTC tried to stabilise the situation by
issuing a statutory interpretation that stated that Brent oil
contracts were not subject to the exchange trading requirement
of the Commodity Exchange Act" according to Markham, in what
became known as the "Statutory Interpretation Concerning Forward
Transactions" or simply the "Brent Interpretation" (55 FR
In line with this, "the primary purpose of a forward
contract is to transfer ownership of the commodity and not to
transfer solely its price risk," the CFTC explained in its
recent rule-making. "The CFTC's historical approach to the
forward contract exclusion ... developed on a case-by-case
basis, not by rule." ("Further definition of a swap" publication
pending in Federal Register)
Under the Brent Interpretation, forward contracts are
entered into between commercial market participants and create
binding obligations to make and take delivery without providing
an automatic right to offset, cancel or settle by paying
differences. Any cancellation or offset requires a separate
subsequently negotiated agreement, and any party can refuse to
agree to it.
"It is well established that the intent to make or take
delivery is the critical factor in determining whether a
contract qualifies as a forward," the CFTC observed in a 2010
legal case. The commission has consistently applied a "facts and
circumstances" test to assess whether the parties to a contract
expected or intended physical delivery.
CUSTOMISED OR STANDARDISED?
Like forward transactions, swaps were historically exempt
from CFTC oversight. For years, derivatives users and dealers
argued that OTC swaps were much more customised than
exchange-traded futures contracts and could not therefore be
traded on exchanges and should not be subject to the same
It has long been clear that the customisation of many OTC
swap contracts was designed in part to win better regulatory
While some OTC contracts were tailored to help hedge the
precise grade, quality, location and delivery requirements of
commercial users, others were simply generic copies of futures
contracts that benefited from a more favourable regulatory
treatment, including exemption from position limits and
Fresh rules under Dodd-Frank have reversed that favourable
regulatory treatment. In some ways, OTC swap contracts will now
attract less favourable treatment than exchange-based futures.
"Based upon our extensive analysis of new swap rules and
consultations with a wide variety of customers," ICE explained,
"we believe that these policies will increase the cost and
complexity for swaps market participants, both in absolute terms
and relative to that of futures market participants." (