US Interest Rate Swap Futures: Why Market Participants Would Switch

Executive Summary
The IR swap is in trouble. A regulatory preference for standardized products that are centrally cleared and traded on an exchange is the antithesis of the highly flexible, privately negotiated swaps market. Analysis of the initiatives announced by the Chicago Mercantile Exchange (CME), Eris Exchange and the Intercontinental Exchange (ICE) show that the most significant advantages include margin, trading and regulatory designations.

The requirement to post initial margin for swaps immediately swings the pendulum in favor of futures products. For a swap, initial margin is calculated by looking at the maximum loss (using VaR) over 5 days; for a future, the IM can be calculated using just one day of Value at Risk (VaR).  Investors will need to incorporate the opportunity costs associated with posting margin into the economic benefits of a trade. While portfolio margining for cleared swaps will help alleviate some of the burdens of IM, the futures contracts will require less offsetting positions because of the lower VaR calculation.

From a trading perspective, the swaps market is also disadvantaged when compared to the futures market.  The regulatory and investor-driven shift toward open access, transparent trading platforms makes it more difficult for the existing market making business models to persist; these business models are predicated on information asymmetries that could be destroyed by pre- and post-trade transparency rules. However, exchanges do have block trading rules and mechanisms that allow for off-exchange activity with less onerous transparency rules than what will likely appear in the final Swap Execution Facility (SEF) rules. 

The recent announcement from ICE that it will shift its OTC Cleared energy business to a futures model is instrumental in showing the futures advantage in regulatory designation. Significant players in the OTC energy derivatives market would have fallen under requirements to register as either a major swap participant or swap dealer if the ICE contracts remained as swaps. Under the new regime, those participants will no longer have to do so. Far from being regulatory arbitrage, we would argue this is exactly the goal of the regulations: simplify the derivatives market and its regulatory oversight through standardization and consolidation.

While the odds seem stacked in favor 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 unfavorable things may appear. 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. But eventually, investors need to show an interest in the contract or it will be consigned to the graveyard of failed contracts. It took years for ETFs to build enough liquidity to be competitive with the underlying basket of securities – but once that occurred ETFs began to gain more attention from institutional investors.

Liquidity alone will not be sufficient to attract investors. One of the key drivers of whether for product selection in rates trading is basis risk – how closely the instrument tracks the type of exposure an investor is seeking.  The customization available in the current swaps market allows firms to be very specific in nearly every component of a swap. The less basis risk there is between the hedge and the underlying, the less the income statement will be impacted by a change in the fair value of either side of the position, which is part of the test for the hedge’s effectiveness that goes into determining favorable tax treatment.

Two new rate swap futures products, the Eris IMM-dated contracts and CME delivery for swaps (DFS) contracts, attempt to preserve some of the features of a swap that can be maintained in an exchange-traded environment.  Both the Eris and CME contracts will clear through the CME; therefore users will be able to achieve margin offsets with treasury futures and cleared IR swaps. Both will trade electronically but will also have lower block sizes, which will facilitate off-exchange trading. This is where the similarities end, however.

The complete version of this seven page Focus Note, including five exhibits, is available on TABB Group’s research site.  It includes the following exhibits: