Sean Owens, Director, Fixed Income and Derivatives, at Woodbine Associates, co-authored this article.
A History Lesson
After three decades of increasing use of OTC derivatives for sophisticated, customized and even generic forms of risk transfer (call it “swap-ification” of risk), the frameworks being implemented via Title VII and Basel III are compelling participants to migrate to more generic products for trading and hedging. Market participants have begun turning to futures as capital-efficient, low-cost alternatives for generic risk transfer. Hence the new era of “future-ization.”
In the interest rate markets, competing swap futures recently began trading. While past initiatives for interest rate swap (IRS) futures have been unsuccessful, we think it will be a different story this time.
Many solid capital market offerings have not been successful due to poor timing or the lack of sufficient impetus for participants to adopt them. For example, Blackbird, a technology start-up, launched an electronic swap trading platform in 1999. The innovative trading platform leveraged technology in the IRS markets and could be considered similar to a present-day alternative trading system (ATS) or swap execution facility (SEF). Unfortunately, the timing was off: there was no compelling need or regulatory impetus driving dealers or participants to trade on the platform.
CME launched the original interest rate swap futures contract more than 10 years ago, but it never gained traction. While the product has obvious merits (as a cleared hedging alternative to mitigate counterparty risk), it has yet to attract sufficient volume or liquidity or use on a widespread basis. This can be attributed to a variety of factors at the time of launch. Cost (clearing cost and initial margin) was comparatively high relative to a swap. The future contract’s structure, which called for cash settlement and did not offer the same convexity as a swap, did not appeal to participants. Furthermore, existing market convention at the time, the use of CSAs to mitigate counterparty risk, was viewed as sufficient.
In the end, the swap futures contract failed to generate discernible volume and liquidity because there was no compelling reason for participants to trade the contract. To the contrary, IRS liquidity concentrated in the inter-dealer market, combined with the relatively low cost of trading swaps in terms of capital, margin and execution cost, proved superior.
There were compelling reasons to turn to the OTC markets to transfer risk. The swap markets offered a highly liquid market for participants to transfer risk, both in customizable and generic terms. The depth and liquidity of the IRS market, created by customized end user hedging, made it the more attractive market for generic risk transfer.
Back to Today
Title VII of the Dodd Frank Act (DFA) changed the rules and market structures for the OTC derivative markets. Basel III similarly altered the quantity of capital needed and its associated cost for banks and financial firms. The cost structure for OTC derivative transactions has changed dramatically, in addition to changes in methods of execution and post-trade requirements. These factors will affect market participants (both directly and indirectly) through their reliance on bank dealer liquidity as their trading counterparty.
Transaction costs as measured by capital and margin are now directly related to the degree of customization offered by the product used. As depicted below, highly customized swaps that are not clearable will be most expensive and subject to credit valuation adjustment (CVA), Value-at-Risk (Var) under Basel III, and will likely require 10-day Var calculations for initial margin (IM). Standard swaps that are required to be cleared will carry a 2% capital risk weight with 5-day Var IM and future commission merchant (FCM) imposed clearing costs. Futures will have significantly lower IM requirements, clearing and capital cost. This cost structure is no accident: it provides incentives for the use of generic and standardized products that can be centrally cleared and easily managed in a stressed or default scenario.
Accordingly, the introduction of new generic futures contracts, deliverable swap futures from CME and quarterly cash settled contracts from Eris, are likely to have cost-driven reasons for broad use. Both offer capital efficiency through favorable treatment, 2-day Var margining (at present, with 1-day Var likely in the future) versus 5-day Var margining for cleared swaps or Eris’ flex-futures. Participants have a choice between cash settlement (Eris IMM contracts) or swap delivery (CME contracts).
We do not see either contract replacing the swap market. Yet, both offer attractive, capital-efficient alternatives for generic risk transfer at a time when participants, particularly banks, face significantly higher capital and funding costs.
Factors making these instruments compelling alternatives to cleared benchmark swaps include: favorable capital treatment (for both the end user and clearing FCM); lower IM requirements; increased netting and margin offset with other listed products; and lower clearing cost. In addition, differences in execution requirements (key SEF/Designated Clearing Market (DCM) final rules and core principals are still pending), including lower block trading thresholds, may result in greater flexibility for futures execution relative to swaps.
Futures contracts also offer operational benefits relative to cleared swaps. These include ease of termination, no need for compression and the ability to use existing infrastructure and technology. The use of futures may allow some participants to avoid some, or all, of the new swap market regulation. These advantages are augmented by participant’s familiarity and comfort level trading futures contracts electronically.
Working against these contracts is the cost of rolling a hedge forward and the lack of current trading volume and liquidity.