Responding to the CFTC’s reproposal of its block trade regulations under Title VII of the Dodd-Frank Act, the hedge fund industry strongly believes that the granularity of the swap categories in the interest rate and credit asset classes can be improved by taking into account the different product types within each asset class. In a letter to the CFTC, the Managed Funds Association said that improved granularity is important to avoid “mixing apples and oranges”, both when selecting the appropriate data to calculate minimum block sizes for a given category of swaps, and when applying such minimum block sizes to specific categories of swaps within each asset class.
The reproposed regulations would define the criteria for grouping swaps into separate swap categories based on common risk and liquidity profiles; establish methodologies for setting appropriate minimum block sizes for each such swap category; and provide protective measures to prevent the disclosure of the identities, business transactions and market positions of swap market participants.
In the view of the MFA, the granularity of the swap categories can be improved by taking into account different product types within each asset class, such as in the interest rate asset class, distinguishing between plain vanilla interest rate swaps and swaptions. Otherwise, the MFA said that the Commission’s proposed groupings by spread and tenor for credit and currency and tenor for rates is sufficient.
The MFA also suggested that the proposed initial minimum block sizes should be calibrated against current market conditions, rather than based exclusively on a limited, three-month data set from 2010. Selected adjustments to initial minimum block sizes may be warranted due to a combination of the noted granularity concerns in swap categories and limitations related to the size, composition, and timeliness of the data set that the Commission used to set its proposed initial minimum block sizes for swap categories in the interest rate and credit asset classes.
The MFA is also concerned that the proposed use of a rolling three-year window of data for calculating post-initial minimum block sizes would unnecessarily constrain the Commission’s ability to shorten that look-back period if material changes in market conditions were to warrant looking at a smaller set of more recent data. Thus, the hedge fund association urged the Commission to retain the flexibility and discretion to update the post-initial minimum block sizes on a case-by-case basis where appropriate, for example, by narrowing the look-back window if needed due to material changes in the trading activity in a given swap category.
The group also believes that the cap sizes for public reporting purposes should mirror the minimum block sizes for each swap category. The MFA does not want the CFTC to burden itself with extra calculations, ongoing maintenance responsibility of separate cap size data on its website, and other administrative work that will likely result from market participants seeking exemptive relief or interpretive guidance based on any anomalies between post-initial cap sizes and post-initial minimum block sizes.
More broadly, the MFA noted that, if swap categories are properly distinguished in the final regulations, the Commission’s proposed 67 percent notional amount calculation provides a viable methodology to calculate post-initial minimum block sizes. However, if swap categories are not properly distinguished, and the Commission cannot ensure a calibration of the initial minimum block sizes to current market conditions, the MFA would be hesitant to endorse the 67 percent notional amount calculation in the final regulations, preferring instead that the CFTC use a 50 percent notional amount calculation, particularly in the initial period, with a phase-in to a 67 percent notional amount calculation over time.
Returning to the granularity issue, the MFA emphasized that further granularity of swap categories is warranted since, as proposed, swaps with materially different trading profiles involving number and frequency of trades and the number of counterparties would be grouped together in a single swap category. If swap categories are set too broadly and capture dissimilar product types, warned the MFA, the resulting blended data set, when subjected to the notional amount calculation, would yield a minimum block size that is theoretically too low for certain swaps in the category and too high for others.
While the MFA appreciates that the Commission has taken care to address such results by proposing groupings that sufficiently address this issue along some differentiating factors, the CFTC should also consider the fact that there are a limited, though materially important, number of distinct product types within each asset class that could be used to further distinguish categories for setting minimum block sizes.
By introducing this additional granularity by product type within an asset class, the MFA believes that the Commission would obtain better tailored initial and post-initial minimum block sizes, irrespective of whether the notional amount calculation is based on a 67 percent or 50 percent figure. In fact, with this refinement, the Commission may well obtain an appropriately higher minimum block size for more standardized, liquid, or on-the-run swap categories, and similarly, an appropriately lower minimum block size for less standardized, liquid, or off-the-run swap categories.
Thus, the MFA strongly recommended that the Commission establish separate swap categories for each product type, in addition to the existing groupings by currency and tenor. In the hedge fund association’s view, this change will result in better tailored minimum block sizes. If distinguishing among five to ten product types appears too complex, the Commission should consider distinguishing between those products that are cleared today by LCH and CME or become clearing-eligible, and those that are not, which, at a minimum, provides a more viable delineation among products.