As market participants and observers wait to see what shape the over-the-counter swaps market will take in its transition to electronic trading, a corner of the futures market will be observing the OTC swaps transformation just as intently.
Introduced roughly a year ago to coincide with new OTC swaps mandates, swaps futures share some traits of swaps, but trade on futures exchanges, where they face less onerous regulations and can tap into the technological efficiencies of established trading and clearing platforms.
The current swaps futures products are interest rates instruments and are traded on the Chicago Mercantile Exchange and Eris Exchange, which has offices in New York and Chicago. The notional value of the combined total of the products trading on the two exchanges now exceeds $20 billion. To put that in perspective, the total notional value of interest rate swaps is estimated at more than $300 trillion, according to the International Swaps and Derivatives Association.
“One of the trends you have seen over the last couple of months is, open interest has been rising. Although it’s coming from a small base, [it] has been increasing steadily. But it’s still a minor fraction of overall OTC interest rate market,” said Matt Simon, Tabb Group head of futures research.
For some, the enormity of the OTC swaps market is indicative of the size of the opportunity. While no one expects swaps futures to take over the OTC swaps market, a movement of 5 percent of the massive OTC swaps volumes into swaps futures would be a huge win for futures markets.
The products that fall into the swap futures class vary widely. The CME’s deliverable swap futures trade as a futures, but as their name suggests, they deliver as swaps cleared at the CME if held through final settlement. The CME deliverable swap futures have standardized coupons that equate to what the industry calls Market Agreed Coupons. They offer two-year, five-year, 10-year and 30-year contracts, meaning the selection includes longer-dated contracts sometimes associated with the swaps market.
“We felt that our deliverable swap future would be more efficient for the marketplace from a capital margin and overall fee and cost perspective than swaps themselves,” said Sean Tully, managing director of interest rate products for the CME. “For example, since it is a standardized swap contract, our deliverable swap future only requires a two-day margin period of risk. Under CFTC regulations, interest rate swaps, because they can be highly customized, have a five-day margin.”
In addition, as swaps are moving toward electronic trading in a new environment, deliverable swap futures allow CME Group customers to leverage an established electronic trading environment, namely CME’s Globex platform, for trading products with similarities to swaps.
“With the regulations around interest rate swaps changing, there is huge uncertainty about what the electronic landscape will look like and where the liquidity will be,” Tully said. “We are leveraging the existing Globex platform to provide liquidity to the marketplace in a reliable manner in this time of uncertainty.”
Approximately 25 to 30 percent of CME Group deliverable swap futures contracts are currently going to delivery as swaps, depending on the delivery month, according to Tully, suggesting participants are testing the products’ delivery mechanism into swaps.
Meanwhile, Tully notes that while swap futures are an alternative choice, CME Group also remains committed to OTC swaps through its clearing unit, which now has 425 global market participants representing 30 percent market share of OTC dealer-to-customer clearing.
By contrast, Eris Exchange’s swaps futures products remain futures contracts and never convert into swaps. Instead, they are more similar to swaps in their ability to customize dates.
“When people think about futures, they generally think of highly standardized contracts. On the other hand, OTC swaps are bespoke instruments that can be highly customized. Additionally, when people think of futures, they think of exposure that can only be held for a short period of time, like Treasury futures. The OTC market offers long-dated contracts-10, 20, 30, 40, even 50 years-that can be held to maturity,” Kevin Wolf of Eris Exchange said.
Eris offers two products: Eris Standard and the more swaplike of the two, Eris Flex. Eris Flexes’ similarities to swaps stems from their highly customizable structure and longer contract dates, which don’t require rolling or physical delivery, like other interest rate futures. Specifically, an Eris Flex can be bought with any effective date out to 10 years (the effective date being the date fixed and floating amounts start to accrue) and any maturity date up to 30 years following the effective date.
Wolf says many of the participants on Eris Exchange are firms that have traditionally operated in both the OTC swaps and the futures markets. “They have a back office that efficiently processes futures and they are already posting margin to CME Clearing through their FCM for cleared trades. In terms of infrastructure, it is in some ways analogous to signing up to trade another futures product,” he said. The exchange is also seeing increasing activity from futures traders that were not involved in swaps, he said.
PREDICTIONS FOR FUTURES GROWTH
The first 2014 milestone in the swaps market comes in mid-February as certain OTC swaps move to mandatory electronic trading on swaps execution facilities. Wolf expects mandatory trading of OTC swaps to have more of an impact on swaps futures than mandatory clearing.
“The open interest has continued to climb through the clearing mandates, but it’s still early in the market evolution. SEF trading rules will drive a lot of business to Eris Exchange because the SEF rules impact the trader. The impact of clearing on the product selection is yet to be felt, because many firms are not yet at the point where the individuals making the execution decisions are being hit with the economic costs associated with clearing,” Wolf said.
But with so many variables, demand will be hard to predict.
“I think no one can make predictions with any certainty. We have never had this kind of disruption to any market across the board,” said David B. Weiss, a senior analyst covering global derivatives at Aite Group.
Sapient Global Markets manager Ben Larah expects many market participants will stick with swaps because they can be customized to provide a static hedge. “When there is a mismatch in maturity and duration between the liability and the hedging instrument, constant rebalancing might be required to hedge the liability,” he said.
Others say they have heard buyside firms say the new OTC regulations will be unmanageable. “I have spoken to firms that said they are going to switch to futures and not trade cleared OTC because of their particular circumstance. I have definitely spoken to firms that are going to do that, but that decision is specific to each firm,” said Ted Leveroni, Omgeo’s executive director of derivatives strategy. For example, some firms that traded only low volumes of OTC swaps might find the transition to cleared and SEF traded swaps too burdensome to justify the effort, he said. In addition, firms with low volumes might have trouble finding a clearing broker.
Tabb Group’s Simon said he has heard of preliminary interest in swaps futures, but that kind of interest is hard to quantify. “What we are finding in our outreach to leading firms in the FCM community is that the dealers and banks that are going to help facilitate trades for these products are getting asked more questions about connectivity to the exchanges that offer swap futures. Their clients are trying to get a better understanding around what the products are,” he said. “As that interest grows, I would expect demand to build and then you might see some market makers getting involved as liquidity providers.”
Meanwhile CME is optimistic about growth. It has already announced plans to launch euro-denominated deliverable swap futures in April, and is weighing adding additional contracts. “We are certainly looking to add additional currencies and tenors; that will be based on market demand. As we feel we have a critical mass, we will launch additional products,” Tully said.
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