DRW, one of Chicago’s top of the bill trading firms, has filed a lawsuit against watchdog CFTC. It’s a strange story – at first it sounds like we have a bad loser in the game. But no such thing. The real news seems to be the CFTC is lacking critical expertise.

Interest rate swaps and futures

The fuzz is about listed interest rate swap futures versus OTC swaps. Nasdaq introduced the futures in order to grab some of the OTC swap market. The futures should replicate exactly the swaps. However, there is a little difference in margin treatment.

Interest, margin and collateral

In short, the side of a swap contract which is in the money receives collateral from the other side, but pays interest over the collateral. The same goes for futures, except we call this margining and the receiver of the margin can keep the interest. These contracts are based on interest rates, so you can picture the catch.

Arbitrage between swap and future

The futures and swaps are related things with different prices, but DRW was able to arbitrage the spread against counterparties Jefferies and MF Global. After building their position, they started to quote the future according to their own fair value.

DRW changed closing prices

CFTC is about to charge them for market manipulation. Because DRW changed the closing prices. That’s scary. Quoting tighter around the fair value price is a valuable component of the price discovery process. DRW is filing a pre-emptive lawsuit against CFTC to stop them filing an enforcement action against DRW. Don’t recall any market participant ever suing the Dutch AFM.

More coverage on Bloomberg and especially here in a post from Craig Pirrong.