Trading & Execution

Priced out of the swaps market

Why does the buy-side need to reassess the way it trades derivatives?

It's all about trading costs. The new swaps era is beginning to become reality in the US and Europe and will hike costs for buy-side firms that typically use OTC derivatives to hedge their exposures.

The obligation to clear swaps which can be standardised will pose the biggest challenge and additional costs. Buy-side traders now need to post initial margin against their swaps for the first time and face more formalised variation margin payments.

This fact alone could make it uneconomical for the buy-side to use OTC derivatives as hedging instruments and is compounded by the expected collateral shortfall.

Clearing houses, which are responsible for deciding the assets they accept as collateral payments, are currently favouring the use of cash and high-grade sovereign bonds for margin use. Buy-side firms which are not rich in these assets will have to seek collateral optimisation or transformation services.

While various providers, including international securities depositories and custodian banks, are scrambling to launch collateral solutions, such offerings are not expected to come cheaply.

So what are the options for the buy-side?

For those institutional investors which are infrequent users of derivatives, or have cash or sovereign bonds that can easily be put to work as collateral, use of swaps will largely stay the same.

Other institutional investors which find the cost of the new rules too prohibitive may need to seek a different route, perhaps through listed derivatives.

However, using listed derivatives may not offer the same kind of tailored exposure available in the OTC market, so a risk assessment may be needed before going down this route. Anecdotal evidence suggests buy-side firms are seeking consultants to help them get a better handle of the overall costs associated with the new swaps trading era.

US markets are offering another way of solving the added costs associated with the new swaps world with the creation of 'futurised swaps'. Such products require the buy-side to pay less initial margin compared to OTC derivatives.

Last December, market operator CME Group began offering deliverable interest rates swaps (IRS) futures that provide the transparency, liquidity and margin efficiency of futures contracts but are cleared as interest rate swaps at the contract's expiry. CME's move followed in the footsteps of a similar move by IntercontinentalExchange for energy derivatives.

Industry observers believe the trend won't stop there; with other futurised products, potentially including FX swaps, believed to be on the horizon.

What has been the preferred route for the buy-side up until now?

In Europe, it's difficult for the buy-side to make any firm decisions, given continued regulatory uncertainty.

Policy makers in the region are still finalising the technical standards that underpin EMIR, which include rules governing: the authorisation of CCPs; which instruments will be made eligible for clearing; margin calculations for more complex derivatives which can be cleared. Finalisation of these aspects are vital in facilitating the buy-side's preparation for the new rules.

In the US, futurised swaps are gaining traction. Over 37,000 IRS futures have been traded on CME since their launch in December, and US regulator the Commodity Futures Trading Commission will hold a roundtable on 31 January to assess their use.