Despite volumes of swap futures growing at a slow pace, there has been a flurry of activity in this space as more exchange groups throw their hat in the futurisation ring. Is there enough room for all of the providers? Is the key to long-term success the offering of a variety of types of swaps futures? Lynn Strongin Dodds explores.
The swap future landscape is getting more crowded with a flurry of activity over the past few months. Established players such as InterContinental Exchange (ICE), CME Group, Eurex and Eris Exchange along with fledgling GMEX are jostling for position while the London Stock Exchange (LSE) and Nasdaq are considering throwing down their gauntlets. The question is whether there are enough slices of the pie to go around.
The jury is still out. “Swap futures will have an impact but it will be staggered as the regulations are phased in,” says John Barclay managing principal in risk consulting at GFT. “The US is currently the main market as Dodd Frank has already been implemented and to begin with these swap futures will nibble away at the smaller end of the interest rate swap market. Overall we see volumes growing significantly this year but this is not as explosive as people expected. It will take time before the market develops due to the complexity and the fact that you will not see uniformed liquidity across all contracts.”
Christopher S. Edmonds, senior vice president, financial markets at ICE notes, “As with any new product there is a reluctance in the marketplace to be the first mover. As participants become more comfortable with the pricing mechanism of these futures and open interest grows, we expect to see more and more market players begin to trade the products.”
Swap futures though are not entirely new. The first incarnation was launched by CME over ten years ago but it never gained traction mainly because buy side firms had no compelling reason to make the switch. The environment is different today given the burdens of the additional margin and collateral requirements under the new derivatives regime. The exchange-traded swap futures which are designed to replicate the exposure offered by over-the-counter (OTC) contracts are seen as a cost effective alternative.
Another bonus is that swap futures are subject to a two-day value at risk (VaR) treatment versus the five and ten day VaRs for standardised and non-standardised swaps, respectively. The discrepancy is down to historical reasons. Futures are marked-to-market on a daily basis while the swaps market has its foundation in OTC bilateral trading, which valued positions less frequently and incorporated a more conservative risk calculation.
One of the challenges facing the market is that unlike the customised OTC trades, swap futures do not provide an exact hedge. However, as Lifan Zhang, a principal consultant at consultancy Catalyst notes, “It will depend on the buy side firm. Some will like the standardisation and rather keep 50p in the pocket so to speak and have an approximate hedge with a swap future while others will want to tailor their cash profile and hedge their liabilities more exactly, using OTC contracts. This depends on your attitude to the basis risk. There is a bigger question for firms at the margins who are small OTC users: how do they want to interact with the market and whether their small OTC volumes justify the heavy burden of trading and clearing OTC or whether an approximate hedge from a standardised product will suffice.”
Edmonds adds, “The pricing mechanism is such that the net present value of the underlying swap, the realised cash flows and the equivalent un-cleared OTC collateral cash flows are all included in the economics. The buy side would utilise the product to obtain the true economics of the OTC swap market but be able to clear the product, complete with all appropriate cross-margining offsets, alongside all other interest rate futures.”
Many exchanges which believe there is potential to be tapped are drawing their battle lines in the sand. “To date, there are three exchanges that have live contracts but there are quite a few newcomers that are waiting in the wings or already in the pipeline,” says Stephen Loosely, partner of consultancy Catalyst. “However, activity is still a drop in the ocean compared to the total notional value of interest rate swaps in the OTC market which is estimated at more than $300 trn, according to the International Swaps and Derivatives Association.”
For example, the report card from Chicago based futures exchange Eris, a start-up founded in 2010 which launched its interest rate swap future in October 2011 shows $47.8 bn was notionally traded in 2014. Although this is a relative minnow compared to the OTC markets it still represents a hefty 160% hike over 2013 figures. In addition, open interest nearly doubled to 147,000 contracts.
CME, a pioneer in the field, which introduced its new generation– the deliverable swap future in 2012 also showed gains. Open interest peaked at 156,500 contracts, representing $15.6 bn last year. As the regulations have been implemented we are seeing an increased focus on total cost of trading from our clients and futures commissions merchants,” says Agha Mirza, CME Group global head of interest rate products. “Depending on the instruments and holding periods, swaps are between 20% to 50% more expensive than swap futures, and up to 100% more expensive than comparable Treasury futures.”
CME has also made a foray into Europe last spring with its euro-denominated deliverable interest rate swap. It was joined later in the year by Eurex, the Deutsche Börse-owned derivatives exchange, which became the first European exchange to launch a swap future, backed by a patent belonging to Goldman Sachs.
The German exchange is also backing GMEX, a fledgling derivatives venue that is set to introduce its interest rate swap future within the first half of the year. Its offering differs in that it packages an OTC interest rate swap into an exchange traded product and is priced using a proprietary benchmark known as the Constant Maturity Index. It tracks every point on the yield curve, retaining its maturity throughout the lifetime of the trade. “Our approach is much more granular compared to using an interest rate swap to hedge a five-day margin, because we are a two-day VaR product and that effectively becomes 75% to 80% cheaper on the cost of margin, “according to GMEX CEO Hirander Misra.
The competition is only set to intensify with ICE, the world’s second largest by market capitalisation, signing a licensing agreement with Eris Exchange as a launch pad for both and US credit default swap (CDS) futures this year while the LSE is thought to be joining forces with a consortium of the largest investment including Goldman Sachs, JP Morgan and Barclays, in what has been dubbed Project Rita to launch a deliverable swap future, though other types of interest rate futures are also in the pipeline.
Michael Riddle, chief operating officer at Eris, adds, “I would say that swap futures is an idea whose time has come in the US, driven by the Dodd Frank implementation. The swap market, though, is still bifurcated and is still very much driven by the request for quote model. This will change, though. Europe’s swap reform has yet to be fully implemented, which is why now is a good time to prepare to launch a product.”
Misra also believes that “there has been a volume shift and that we will see a steady flow in line with the regulation changes. However, our view echoes Eurex in that different types of users will need different types of contracts. As a result, the market will need more than one – perhaps two to three flavours- to support the variations.”
