It is not illegal to be smarter than your counterparties in a swap transaction

"It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product."

Richard J. Sullivan
United States Circuit Judge
30 November 2018

This is an interesting statement from the judgement in the United States in the case "CFTC versus Wilson and DRW" (full text available here).

The text of the judgement provide a (surprisingly?) good explanation of derivatives market, including convexity effect on futures. The judgement relates to IDEX 3-month futures. Those futures are not traded anymore since 2011. The text includes consideration about variation margin, basis risk, PAI, convexity adjustments, and futures design.

The background is a badly designed swap futures where some participants notice the bad design and its implications while others didn't. The marketing of the futures claimed that "IDEX IRS futures are designed to be economically equivalent in every material respect to plain vanilla interest rate swap contracts currently traded in the OTC derivatives market" (see marketing flyer here). The "economically equivalent" had to be taken with a poetic license, some market participants (and the clearing house) took it at face value to some extend.

CFTC was suing DRW for biding in this very illiquid market at a price closer to the DRW estimated fair value than the unadjusted OTC swap price. As DRW was the only bidder in this illiquid market, DRW was actually the daily settlement price maker.

My comments are not about the manipulation case but about the futures design. Bad designs of swap futures are dangerous in a market with trillions notional underlying. If you are planning to trade those products, don't take marketing and "every body is doing this" at face value, specially in the flow/linear products interest rate market. Analyze all the facets of the product, including cash flows, settlement mechanisms, regulation, margin (variation and initial), convexity adjustment with respect to other flow instruments, comparison with liquid products, hedging strategies, etc. Innocuously looking effects may have a large value in markets with huge notionals. If you are an exchange planning to launch a contract, get independent opinion or advice from experts, don't be seen as someone who don't understand its own products as well as its clients.

I have proposed a swap futures design that is very close to the OTC market in quotation mechanism and convexity adjustments: see my blog post and detailed technical note.

When you deal with new products and related markets, choose your experts well. Make sure he understands the market your are trading in from inside and all the details of its functioning. Do not choose one of which your shareholders (or a judge in the case described above) could say that his "assertions [are] absurd", as the CFTC did.

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