The Feckless CFTC Strikes Again

A little publicized news story came out the other day.  The Chicago trading firm, DRW, is suing the CFTC.  I am glad someone is finally doing it.

At issue is whether DRW manipulated the prices of illiquid contracts.

In my experience, which is limited in this kind of trading, it’s pretty hard to believe that they did.  There isn’t a federal agency out there today that doesn’t have an agenda and the CFTC is no different.

My gut tells me that DRW went into the market and beat a bunch of New York banks at a game they were trying to control.  Instead of figuring out how to compete, they phoned their regulator.

Streetwise Professor has an excellent analysis of the whole thing.

The details are kind of geeky, but I’ll try to summarize in as close to plain English as I can.  At issue is DRW’s trading-and quoting-of swap futures contracts traded on the Nasdaq Futures Exchange and cleared on the International Derivatives Clearinghouse.  As a cleared contract, the swap futures was subject to daily mark-to-market.  OTC swaps (at the time) were not collateralized or subject to mark-to-market.  As basically anybody who has been around futures markets since the early-90s knows, this differential margining treatment should cause swap prices to differ from futures prices.

Hell, this has been known in the academic literature since 1981, with the publication of a paper by Cox, Ingersoll, and Ross.  The basic idea is that marked-to-market futures have payoffs that are linear in the interest rate, but swaps have payoffs that are a convex function of the interest rate due to discounting: futures cash flows respond immediately to interest rate changes due to daily variation margining, but the effects of interest rate changes on the swap are not realized until the expiration date of the swap.  This leads to a “convexity bias”: the futures are biased relative to the swap, due to the fact that with discounting, the present value of the swap cash flows are a convex function of interest rates.

DRW recognized this difference between the swap and the futures.  Hence, it did not enter quotes into the futures market that were equal to swap yields.  It entered quotes at a differential to the swap rate, to reflect the convexity adjustment.  IDC used these bids to determine the settlement price, and hence daily variation margin payments.  Thus, the settlement prices reflected the convexity adjustment.  Not 100 percent, because DRW was trying to make money arbing the market.  But the settlement prices were closer to fair value as a result of DRW’s quotes than they would have been otherwise. 

Click over and read the whole thing.


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