While the farmer loses the possibility that her corn could sell for more than $5 at harvest time, she avoids the risk that the market price for corn will be less than $5.
Swaps: Contracts in which two parties agree to make specified payments based on the occurrence or nonoccurrence of an event or contingency, such as to exchange a fixed cash flow for a variable or floating cash flow for a specified period of time, in the case of a fixed-for-floating interest rate swap, or for payment in connection with a “credit event”—such as borrower default—in the case of a credit default swap.
Private sector enterprises face not only the consequences of harsher and more frequent fires, droughts, floods, and other physical disasters but also potential disruptions from other companies along supply chains that fail to prepare effectively for the phase-out of fossil fuels for green alternatives.
Although the commission must address many challenges, this report outlines the top five reforms that would make sure derivatives markets can withstand risks from climate change; are transparent and equitable; and provide for a resilient and stable market structure that ensures counterparty risks are handled within the financial system without harming the real economy.
The CFTC should ensure that products actually provide the benefits they claim and block products that would harm net-zero efforts, such as carbon offsets with insufficient verification.
While the CFTC cannot require reductions in carbon emissions, it can ensure that derivatives markets allow companies that use swaps, futures, and other financial products to hedge against the physical risks of climate change and smooth the transition from fossil fuels.
The CFTC has begun outlining a plan for action.
Last year, for example, it held a meeting to examine the “status of carbon reduction through cap-and-trade and other carbon trading market mechanisms.”13 Also last year, then-CFTC Commissioner Dan Berkovitz gave a speech in which he acknowledged that “the CFTC must be aware of how the various primary, secondary, and derivative carbon markets are interacting and how companies use these markets to meet their compliance obligations, manage risks, and discover prices.”14 While there is certainly value in further study, there are concrete actions the CFTC could take now to help market participants address and adapt to climate change.
A common challenge for companies seeking to measure their carbon emissions is the lack of standards around carbon accounting across a commodity supply chain.
Recent research has found that a warming climate will result in “dramatic increases in the variability of corn yields from one year to the next…which could lead to price hikes and global shortages.”17 Similarly, there is evidence that “extreme weather events and unusual seasonal patterns both gas demand and supply,” again causing price volatility from one season to the next and making pricing predictions difficult.18 This volatility will harm commodity end users—regular customers who rely on corn for sustenance or on gas for heating.
Other regulators are undertaking efforts to ensure that companies understand the risks that climate change poses to their businesses—including heightened physical risks of fire, drought, flood, and other natural disasters, as well as risks from business partners that are not taking similar steps to adapt.
For example, it is clear that offsets relating to forest preservation do not work: For a forest preservation investment to be an effective carbon offset, the forest remain a forest forever, and future logging or even wildfires that result in deforestation will negate offsets that were paid for and counted years in the past.
Moreover, carbon offset markets suffer from challenges relating to double claiming, double counting, and double use,33 which include claiming as an offset emission reduction activity that would have occurred even without the offset’s investment.
Derivatives markets are extraordinarily resilient due to the fact that nearly 70 percent of swaps are conducted through derivatives clearing organizations and assume the counterparty risk originally held by the traders—in effect, DCOs centrally clear trades.
DCOs are so important that the Financial Stability Oversight Council designated several of the largest DCOs as systemically important financial market utilities, subjecting them to increased risk management standards and oversight.
Each time a DCO steps between two parties, each party is required to provide the DCO with initial margin that is expected to be sufficient to address the price volatility of the contract.
Despite their ability to collect capital through this waterfall, DCOs’ importance means that they are routinely stress-tested to ensure that they will survive in times of crisis.37 These stress tests examine DCOs’ likelihood of fulfilling their responsibilities in the event that many of their counterparties fail and DCOs are required to use their own reserves to fulfill their contracts.
Finally, regulators should recognize that DCOs’ survival is threatened not just by financial crises but also by climate change.
Similarly, DCOs should similarly know whether their counterparties’ transactions are so concentrated in one instrument subject to climate risk, such as corn futures, that climate-caused natural disasters would threaten the parties’ solvency.
Second, stress tests must ensure that DCOs’ operations are capable of withstanding climate-related physical risks and that they have contingency plans in place in the event of a climate disaster.
The CFTC should enact new regulations to encourage competition between platforms such that new platforms can enter the market.
Financial markets work most fairly and efficiently when there is competition, and derivatives are no exception.
The most common metric for determining market concentration is the Herfindahl-Hirschman Index .
The maximum HHI score possible under the CFTC’s position limits rule is 2,500, meaning that the CFTC is implicitly permitting a market on the cusp of being highly concentrated—and therefore, is implicitly permitting the heightened volatility that comes with concentration, as speculators may be required to exit their contracts at whatever price the other party demands.
End users rely on these platforms for efficient and safe access to the derivatives markets, but the market for services these platforms operate is highly concentrated—potentially leading to higher prices, worse services, and increased systemic risk than under a more competitive market.
This, combined with the power of individual exchanges, results in two significant problems. The first issue—lock-in effects—is endemic to any monopoly or duopoly; because traders to a contract must agree to use the same DCO, all trades on an exchange end up clearing on one DCO.
The failure of a DCO that clears all or nearly all of a highly traded instrument could ripple to other parts of the financial system, causing severe damage to the DCO’s counterparties and the entities in the financial and real economy with which they transact.
The CFTC should take three actions to ensure long-term competition in the derivatives market.
Department of Justice and the Federal Trade Commission to consider whether the merger violates federal antitrust laws and use their authorities to the extent legally permissible.
The regulation also established a process for collecting those bids and offers from trading platforms. While there are concerns surrounding Regulation NMS and not all of its provisions would translate to the derivatives markets, creating a system in which exchanges can freely compete against each other would be beneficial.
To trade effectively, market participants need information about current bids and offers, as well as prior transactions; in other words, they need to be able to see where the market is and where the market has been, respectively.
CLOBs are the more transparent and equitable system: While RFQs require customers to alert dealers of their interest in trading, CLOBs require all dealers and all customers to provide their best bids and offers and usually allow parties to trade anonymously.
Full information of the type that CLOBs offer is necessary for customers to obtain the best prices, and the asymmetry offered by RFQ systems is shown to result in higher prices for customers.
CFTC regulations require SEFs to offer either an RFQ system in conjunction with a CLOB or a CLOB alone.56 Although all major dealer-to-customer SEFs—including CME, ICE, and Bloomberg57—offer trades on both RFQ and CLOB systems, the latter is rarely used except for the most liquid of instruments because dealers do not proactively post their bids and offers to the CLOB.
For-profit enterprises do not seem well-positioned to pass independent judgment on their own compliance with the law:58 In 2020, one exchange used the lack of regulations governing pre-trade data to increase the cost of obtaining historical data from five exchanges from $0 to $135,000 annually.59 This not only differs from the CFTC’s rules governing the availability of post-trade derivatives data but also from the rules governing securities exchanges’ data, which prohibit charges that are contrary to the public interest or are anti-competitive.60 The CFTC should impose transparency requirements for pre-trade data that are at least as robust as requirements for post-trade data.
Third, the CFTC’s rules governing the availability of post-trade data should also be improved.
A difference of a few minutes can see the price shift dramatically.”63 The CFTC should, through regulation, provide a maximum time by which SEFs must report trade execution information to SDRs, measured in seconds or less, and should update that number periodically as technology improves so that SEFs may be held to account.
The CFTC has an important role to play in regulating the market for digital assets such as cryptocurrencies, as it has sole jurisdiction over nearly 60 percent of the market by capitalization.64 Digital assets exist as entries on ledgers known as blockchains, which themselves consist of records of when assets were bought and sold and to whom.
Additionally, the CFTC has broad authority over other markets, including registration requirements for platforms, dealers, and major market participants.
Not only is there no effective way for traders to arbitrage away this difference—given that exchanges custody clients’ digital assets, as opposed to a third party87—but the price of a given digital asset on an exchange can be manipulated much more easily than the global price.
The CFTC must take steps to ensure that derivatives markets facilitate the transition to net zero; are capable of withstanding climate risks; and are competitive, transparent, and safe for all market participants in every asset class under the commission’s jurisdiction.
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The Center for American Progress is an independent nonpartisan policy institute that is dedicated to improving the lives of all Americans through bold, progressive ideas, as well as strong leadership and concerted action.