Swap futures are hailed by some to be the next big thing given the advantages these products offer but traction is slow. Lynn Strongin Dodds explores the benefits of the swap future and compares the different products currently on offer from some of the exchanges.
The futurisation of swaps may sound like a science fiction novel but these instruments are increasingly igniting interest among the institutional investment community. ERIS Exchange grabbed the limelight three years ago with its offering but stalwarts Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE) have since joined the fray. Others are expected to follow suit but the jury is out as to whether these products will gain meaningful traction in the future.
“It is the million dollar question,” says Jonathan Philp, a collateral management specialist and industry consultant. “The new regulations will be onerous and the furturisation of swaps helps investors get around it. They can get close to the same exposures with a listed product. The CME and ICE just launched their products at the end of last year and ERIS started in September 2010 although it has had low volumes. I think it is very much a wait and see game but the deciding factor will be whoever attracts the most liquidity.”
Will Rhode, director of fixed income at consultancy TABB Group, agree, adding that the success will come down to the end users and their specific requirements. “Some investors will want an OTC or bi-lateral trade in order to customise their exposure to an underlying asset but for many others, the swap future will be a cost effective and efficient way to trade. The hedge may not be an exact match but it will be close enough.”
This is not the first time that these hybrid products have been mooted. The CME listed them in 2009 but they failed to capture the imagination, partly because there was no burning reason for users to switch. That is not the case today. It has been well documented that the new clearing regime will wrought significant charges on the margin front although estimates vary widely. The International Swaps and Derivatives Association (ISDA) for example projects the proposed rules for margining of non-centrally-cleared derivatives could result in a requirement of between $15.7 trillion and $29.9 trillion in initial margin while figures compiled by the Bank of England put total initial margin obligations at between $200 bn and $800 bn.
The other draw is the holding period for futures based on value at risk (VaR) models is one to two days compared to the swap contract’s five days. Moreover, institutional investors are comfortable using futures and are well versed in the operational nuts and bolts. “People have tried to launch swap futures in the past but the main driver today is that we have a product that replicates OTC swaps as well as the motivation from Dodd Frank and other regulations that make the product a viable alternative to swaps,” says Chris Rodriguez, chief sales and marketing officer for Eris Exchange. “The benefits of futures are that they are more efficient in a variety of ways. For example, Eris’s standardised contracts have initial margin levels that are up to 80% lower than cleared swaps. We are seeing very clear evidence that the market will soon shift and this will accelerate as the market becomes more liquid. At the moment, though, it is hard to put an exact figure on it.”
According to Rhode’s colleague, Adam Sussman, TABB Group partner and author of the report US Interest Rate Swap Futures: Why Market Participants Would Switch, the migration will not happen overnight. He points out that it took about 20 months for the CME’s ultra bond futures contract, which made its debut in early 2010 to make a dent. By extrapolating that timeline to the swap futures market and starting the clock at the point in which the clearing mandate applies to non-dealers, these instruments if embraced could comprise at least 3% of the swaps and swaps futures market by mid-year 2014.
“While the odds seem stacked in favour of the futures market stealing at least some business from the swaps market, it should be remembered that the incumbent always has an advantage, no matter how unfavourable things may appear,” Sussman explains. “Any new trading instrument has a steep hill to climb to become an established alternative to the swaps market. Exchanges must work hard to get market makers to agree to post bids and offers at a reasonable spread. However, eventually, investors need to show an interest in the contract or it will be consigned to the graveyard of failed contracts.”
At the moment, large buy side players are crunching the numbers and conducting cost benefit analysis across the spectrum ranging from OTC swaps to traditional interest rate futures and newly minted swap futures. Factors such as the certainty of execution, liquidity, spreads, margin requirements, cross-margining potential, and execution and clearing fees are all being factored in. Some of the small and medium sized firms though may have no choice but to go down this route if futures commission merchants (FCMs) decide as expected to focus on their larger more profitable clients. Regardless of size all players will also have to look at the potential tax treatment of the new products.
The exchanges have already started to mark their territory. ERIS, which was created by five proprietary trading firms including Getco, DRW Holdings and Infinium Capital Management may have been first out of the starting gate but it is not standing still. It recently debuted quarterly interest rate swaps futures that come in two, five, 10 and 30 year maturities and aims to offer 40% to 80% margin savings compared to cleared OTC interest rate swaps. In addition, Morgan Stanley has recently taken a minority stake making it the first large swap dealer to join its ranks.
The US based bank though is not exclusive and is also part of the market making gang supporting rival CME’s new deliverable swap futures (DFS) product which references the same quarterly benchmarks. The world’s largest derivative exchange believes the new contracts can offer margin savings between 45% to 73.5% over that of cleared IRS and futures. Volumes have grown from 782 to 37.717 since being introduced in early December.
“The volume is growing nicely,” says Sean Tully, managing director, interest rate products, at CME Group. “The main attraction of the DSF is that it meets the need for a transparent, simple and standardised product. These futures also allow automatic netting of positions, and cross-margin offsets against our existing futures which offers a cost efficient way to execute trades.”
While both ERIS and CME swap futures are cleared on the CME and offer margin offsets, electronic trading and lower block sizes, the similarities end there, according to the TABB report. He notes that the CME product has more in common with an ETF in that it favours standardisation in order to achieve broad distribution and deep liquidity. It also has a physical-delivery which has the advantage of creating a more natural arbitrage opportunity between the underlying and the future. “Traders who can access both the swap and the future market can take advantage of any differences in pricing and increase the chance that the markets will not have significant tracking error between the two,” Sussman says..
By contrast, the TABB report notes that the Eris product mimics the pay-out of a swap. For example, upon expiration, it does not settle into cash or physical. This is because the coupon and interest accruals are priced into the contract and therefore there is no need for any payments outside of the daily variation margin. At expiration, all of the gains or losses of the contract have been incurred and there is nothing left to settle. The benefit is that the contract manages all the cash flow requirements of the position which means there is no need to have cash or physical assets ready for expiration.
The Eris contract also allows for a degree of customisation in that the user can to adapt the spot or forward starting date for a contract, as well as the fixed rate out to the fourth decimal. The CME does not allow for this and limits to four points on the curve and a minimum number of International Market Money (IMM) dates.
Investors also like choice and there is no doubt that the CME and ERIS have generated a buzz with their different offerings. However, ICE has also created a stir with its decision to convert its cleared energy swaps to futures. According to a company spokesperson, “we transitioned our entire cleared energy portfolio, approximately 800 contracts, to futures. The contract specs, the way they trade and clear, the platform they trade on, the margins and the fees, etc. are all the same as they were when they traded as swaps. ICE’s energy swaps have traded alongside energy futures on the same trading platform via a central limit order book for more than a decade. While the product type is changed, the look and feel of the screen and the manner in which it trades is the same.”
ICE Chairman & CEO Jeffrey C. Sprecher also believes that “given the complexity of the new swaps regulation regime in the US, customers uniformly agreed that futures markets would best serve their hedging and risk management needs in the energy and commodity space, allowing them to operate in a highly regulated regime that they know and understand.”
