Swaps and the CFTC: An Overview
Derivatives — futures, swaps, certain options, and over-the-counter markets — are powerful investments for those with the necessary skillset to trade them profitably.
Globally, derivatives play a pivotal role in minimizing any uncertainty that may arise between exchange and interest rates. Locally, they help with equity, commodity, and credit prices.
According to the Bank for International Settlements (BIS), the United States (U.S.) derivatives market was worth $12.4 trillion in December 2021 — a testament to the inherent hedging power investors trust the market to provide.
In this post, we’re going to limit our focus to one derivative — swaps — by answering the following set of questions:
· What is the CFTC?
· What are swaps?
· How exactly does the CFTC impact swaps?
Without further ado, let’s jump right on in.
What is the CFTC?
Created in 1974, the Commodity Futures Trading Commission (CFTC) is the governing agency responsible for U.S. derivative markets regulation.
This means the CFTC oversees and controls all U.S.-traded derivatives including swaps, futures, and options.
The CFTC has as an objective the creation of financially sound, open, and competitive derivative markets. Consequently, the Commission works hard to protect all major players (arbitrageurs, hedgers, margin traders, and speculators) from abusive financial practices, fraud, and manipulative behaviors.
What are swaps?
Investopedia.com provides us with a comprehensive definition of what a swap is. It is:
“…a derivative contract where one party exchanges or ‘swaps’ the cash flows or value of one asset for another.”
There are at least six different types of swaps.
· Credit default swaps
· Commodity swaps
· Currency swaps
· Interest rate swaps
· Total return swaps
· Zero coupon swaps
1. Credit default swaps
Credit default swaps act as a form of insurance for the borrowing party in a two-way agreement. The lender, wary of the borrower, can initiate a credit default swap with a third party. If the borrower fails to pay back, the lender can file a claim and recoup their losses from the credit default swap agent.
2. Commodity swaps
This derivative is particularly useful between businesses or private individuals engaged in mining activities or the manufacture of goods. Commodity swaps serve to protect against commodity price fluctuations thereby acting as a reliable hedging tool.
3. Currency swaps
This type of swap is an efficient pathway to hedge forex risk. The trade-off entails two entities agreeing to swap currency based on a contract that is favorable for both sides.
4. Interest rate swaps
Of all swaps, interest rate swaps are the most popular. They work by enabling the two consenting parties to trade both floating and fixed cash flows. This exchange is done on an investment or loan that’s interest-bearing.
5. Total return swaps
Say you want to own securities without actually purchasing them. What can you do? Well, that’s where total return swaps come in. Essentially, this type of swap gives investors the opportunity and benefits that come with security ownership without the accompanying risks. This type of agreement can be executed on a number of securities including equities, loans, bonds, commodities, and indexes.
6. Zero coupon swaps
Zero coupon swaps act in a similar manner to interest rate swaps and are particularly useful to two main groups:
· Banks issuing bonds that generate end-of-maturity interest
· Companies seeking to hedge loans whose interest is only paid upon maturity
How exactly does the CFTC impact swaps?
Financial instruments in the U.S. are regulated. The clearest way to understand CFTC’s impact on swaps is to be cognizant of the fact that there exist different bodies to manage the markets in the U.S.
· The Securities and Exchange Commission (SEC) regulates the securities market
· The Commodity Futures Trading Commission (CFTC) regulates the derivatives market
Each governing body has unique responsibilities, and modus operandi, and is subject to distinct laws.
Swaps, being a derivative and not a security, are therefore directly affected by all directives, ordinances, and mandates issued by the CFTC.
This means all major players that are trading swaps must be in compliance with CFTC regulations. You cannot trade swaps while being ignorant of CFTC decrees.
This is the first post in a three-part series on Swaps and CFTC.