Converting Commodity Swaps to net futures-equivalent: Staying compliant with CFTC:s new position limits on Economically Equivalent Swaps

Abstract

Trading commodities has been around for centuries, and today, most trading is done electronically on exchanges in derivatives contracts. Over time, regulatory bodies, specifically the CFTC, have sought to implement safeguards against market manipulation by participants. One such measure has been position limits on derivatives, which since January 1st, 2023, also includes so-called economically equivalent swaps, as an attempt to regulate the over-the-counter market. This paper aims to understand and develop a methodology for converting these now-regulated swaps, into their net futures equivalent, which is required since the position limits are defined in a number of futures contracts.

The paper suggests a four-stage process be employed when converting swaps. Firstly, a referenced contract subject to position limits must be found that is linked to the swap. Secondly, settlement type (cash-settled and physically settled) is used to narrow down the list of potential contracts. Thirdly, analyzing the pricing date is compared to the underlying contracts, as a difference here renders the swap non-economically equivalent. Lastly, the rest of the contractual specifications are analyzed, and if a swap passes all four stages, it is deemed economically equivalent to a referenced contract.

In the discussion, the paper identified several noteworthy remarks regarding the reliability of the proposed method. Firstly, it was mentioned that many of the conversion features were based on CFTCs large trader reporting literature, which hurt reliability. However, the CFTC specifically mentioned that a "best effort"-methodology was accepted for deciding on economic equivalence, something the authors deem the proposed method to be. Furthermore, the scope of the paper was discussed, resulting in some proposed areas of further research that would be interesting to explore further.

Popular Abstract

Effective January 1st, 2023, the Commodity Futures Trading Commission (CFTC), for the first time, included over the counter (OTC) swaps in their position limit regulation. To remain compliant, market participants must now convert their swap holdings into net-futures equivalents, something this thesis aims to assist in doing.

After initial talks with Scila, who help their customers monitor financial positions as a part of their Scila Risk™ platform, it became evident that customers were looking for a way to also monitor their swap exposure, especially with regard to remaining compliant with the recent changes to CFTC:s position limit legislation on economically equivalent commodity swaps. This need is addressed in our thesis by building a method allowing market participants to convert the swaps that they hold, and later determine if it falls under the regulation of economically equivalent swaps, or can be exempt by a number of stipulations presented by CFTC.

To summarize the result of the thesis, it presents what could be seen as a “best effort” with converting economically equivalent swaps, especially when taking into consideration that the CFTC has decided not to communicate clear guidelines on how the conversion of swaps should be done. The “best effort” result might seem counterproductive, however, the CFTC have communicated that if a market participant can prove that they have done their best with regard to conversion of their commodity swaps, they are in fact compliant with the position limit regulation.

Notwithstanding the manual nature of the methodology presented in the paper’s result, it can be utilized to achieve the ultimate goal of the reader - remaining compliant with CFTC:s position limit regulation, especially with regard to economically equivalent swaps. Another use case of the presented methodology, also proposed as further research in the conclusion, would be an automation of the conversion process, allowing affected companies/firms to remain compliant with minimal manual overhead. Hopefully, this might even start a wave of research into OTC regulation and how to remain compliant, covering all of the exchanges available worldwide, and differing regulation depending on the researched region.

One surprise that became clear as we researched the regulation was that it all stemmed from the same historic event that both authors were too young to remember: the Great Recession in 2008. Seeing as derivatives played a large role in the chaos that ensued, one of the pillars of the Dodd-Frank act was to increase the transparency in all derivatives, in many cases by moving OTC derivatives on exchange. Even though this thesis only serves as a small cog in the great machine of financial regulation compliance, we are glad to have made a small contribution to this noble cause.

• author: Marseille, Sébastien and Rasmusson, Kevin
• supervisor: Anders Vilhelmsson
• organization: Department of Economics
• course: EXTM10 20241
• year: 2024
• type: H2 - Master's Degree (Two Years)
• subject: Business and Economics
• keywords: CFTC position limits, economically equivalent swaps, commodity derivatives, commodity swaps regulation, futures conversion compliance, swap exposure monitoring, net-futures equivalents
• language: English
• id: 9157676
• date added to LUP: 2024-11-22 09:05:20
• date last changed: 2024-11-22 09:05:20