Thursday, March 21, 2013 2:07:07 PM

Swap futures could offer greater hedging options

Swap futures may offer market participants greater hedging options, while divergent block trading rules could have a significant impact on liquidity, a report has stated.

As the US' Dodd-Frank Act starts to overhaul the OTC derivatives market, swap futures – instruments that offer the exposure of a swap through a listed future – will offer an alternative hedging option to swaps, provided they develop deep, liquid markets, the report, compiled by financial research and consultancy firm Finadium, asserts.

"Swap dealers will be incentivised to use swap futures for their margin efficiencies – lower initial margin than cleared OTC swaps and cross-margining with other products traded and cleared by an exchange – but will only stay if there is liquidity," the report, authored by Jonathan Cooper, senior consultant at Finadium, read.

More formalised margin and collateral requirements on swaps via the obligation to clear OTC derivative trades under Dodd-Frank Act will increase overall trading costs. The new regulatory regime also requires swaps products to be traded on exchange-like platforms known as swap execution facilities (SEFs), where possible. These changes have precipitated the creation of futures contracts that bear similarities to swaps products.

The report, titled 'The futurisation of the swaps market: players, products and collateral', also claims differences in block trading rules for SEFs and designated contract markets (DCMs), which are yet to be determined, may also push flow towards swap futures.

The minimum block size allows market participants to delay the reporting of large trades, in order to manage market impact. Under current rules, DCMs can set their own block size, while SEFs will have their block thresholds set by regulators, presenting the opportunity for DCMs to create a more favourable regime for trading swap-like products.

"This of course creates the concern that SEF block trading rules are not sensitive to market participantsʼ fears about too much information, released too quickly," read the report. "The DCMs can use their flexibility as a competitive tool. If market participants, and in particular swap dealers and liquidity providers, think that SEF-based trading puts them at a tactical disadvantage vis-à-vis exchange traded swap futures, this will give a competitive advantage to swap futures."

In the US, the three exchanges that created swap futures are the Chicago Mercantile Exchange and Eris Exchange for IRS products, and the IntercontinentalExchange for energy swap futures.

Richard Henderson +1 212 217 6916