Innovation spotlight: Swap futures

Additional costs and margin and collateral requirements for trading interest rate swaps have paved the way for the development of swap futures products in Europe and the US.

The needs of buy-side firms are rapidly changing in the post-crisis and regulatory-driven environment, sparking a wave of new product innovation. This week, looks at five evolving products and how they are playing their part in the new derivatives market unfolding before our eyes. First up: swap futures.

The mandatory central clearing of OTC derivatives has led to an abundance of additional costs, including additional margin and collateral requirements. Formerly a bilateral process, swaps trading now involves central counterparties (CCPs), signing up with clearing members and a whole lot of extra compliance. The cost and complexity of swap trading has seen swap futures emerge as a cheaper way of hedging interest rate risk in particular.

One of the luring factors for participants is that listed derivatives are subject to a two-day value at risk (VaR) treatment, as opposed to five-day and 10-day VaRs for standardised and non-standardised swaps, respectively. Pioneered in the US by CME Group and then by Eris Exchange, some buy-side firms are finding that trading swap futures can reduce the cost of executing and clearing compared with OTC trades. Interest rate swap futures in particular should be liquid enough to be listed on a central limit order book rather than traded OTC then centrally cleared. But in the US, the products are still waiting to take off despite some steady growth since their inception. Open interest on Eris, for example, rose to over 100,000 outstanding contracts earlier this year, after launching in 2010.

Buy-side firms remain slow in adopting the use of swap execution facilities in the US, and the anticipated explosion of activity in swap futures has not yet materialised. The growth however, could be set to occur the deeper we get into the new regulatory landscape.

In Europe, the battle could be even more intriguing with the major exchanges all looking at a potential swap futures launch. Nasdaq OMX’s NLX and the London Stock Exchange have been rumoured to be looking into the products, while Eurex and new players like GMEX are set to launch their offerings before the end of the year.

“Every exchange is getting ready for the futurisation of swaps,” said Nadja Urban, SVP, product development, Eurex. “The swap market is a big market with many opportunities due to the fact that the regulatory environment will lead to structural changes, so of course every platform or exchange is taking the opportunity to take a part of this business.”

Eurex believes it holds the upper hand due to its cross-margin efficiencies it can offer across cleared OTC and exchange-traded swaps, where firms can benefit from offsets.

The initiative will come into force as regulations increase the costs of clearing, allowing buy-side firms to reduce their expenditure.

“With our exchange and clearing house you have a lower margin compared to a cleared swap, a two-day liquidation horizon, cross-margining with our listed fixed income offering, and the cross-product margining between Euro swap futures and the Eurex OTC cleared interest rate swaps,” added Urban.

Eurex’s offering went live on 1 September this year, representing Europe’s first swap futures contract.

GMEX has developed its own form of swap future by basing the contract on an underlying index designed to reflect pricing in the interest rate swap market in real time. The constant maturity future is linked to GMEX’s proprietary Interest Rate Swap Index Average and tracks every point on the yield curve, retaining its maturity throughout the lifetime of the trade.

Says Hirander Misra, CEO of GMEX, “We are banking on being a much more granular hedge, compared to using an interest rate swap to hedge a five-day margin, because we are a two-day VaR product we effectively become 90% cheaper on the cost of margin.”

What differentiates GMEX’s launch is that this contract is not an attempt to futurise a swap but to launch futures on an index which replicates the daily interest-rate swap market. “A lot of firms are looking at the balance sheet implications of mandatory central clearing and working out whether they can hedge more effectively,” says Misra.

Although swap futures potentially offer investors a cheaper alternative, this must be offset against the fact they won’t necessarily deliver the perfect hedge.