It looks like institutional use of swaps as an investment vehicle has seen its day and futures are slated to replace them in portfolios.
That’s the view of Greenwich Associates, a market consultancy, which pointed out in a new report that new liquidity and capital rules will widen the cost difference between cheaper futures and standardized cleared swaps.
“Our quantitative model used in this research identifies generally favorable liquidity cost dynamics for futures in many cases as the regulatory headwinds impacting the swaps market will not die down,” said Awad, a managing director at Greenwich Associates. “In fact, impending derivatives regulations in Europe, in tandem with changes to risk-weighted asset calculation requirements, will only make trading swaps more costly as time goes on.”
In its new report, “Total Cost Analysis of Interest-Rate Swaps vs. Futures,” which employed trade cost analysis and interviews with over 40 U.S. market participants, found futures to be the least expensive alternative for expressing views on interest rates in nearly every scenario analyzed with liquidity costs as the largest contributor to the gap.
Furthermore, Greenwich noted that while the impact of higher margin requirements for swaps has had limited impact on product selection to date, it will move the needle in the coming years as clients have less eligible collateral on hand.
“In addition, the liquidity cost gap between swaps and futures demonstrated in the research will likely widen as banks find it more difficult to make money trading cleared swaps with new regulations,” the report said.
However, swaps and their usage is not expected to disappear, the firm reported. Its research also revealedthat swaps, both cleared and bilateral, will continue to have their place and those markets will remain robust, albeit on a smaller scale than previously.
“Many market participants are willing to pay up for customization that the swaps market allows and our models show that the cost differentials will benefit those in this camp,” said Kevin McPartland, head of market structure and technology research at Greenwich Associates.
The study also examines roadblocks, both perceived and actual, for further adoption of futures despite the cost savings. Among the biggest roadblocks cited by investors were concerns about liquidity for trading large blocks in certain products, operational changes required and cultural barriers that exist within certain investment organizations.
