Trading volumes in interest rate swap (IRS) futures will grow as investors seek more cost-effective ways to hedge risks, but the new contract type is unlikely to overshadow the growth of cleared OTC derivatives.
Despite a slow take up of IRS futures offered by US bourses CME Group and Eris Exchange, analysis from consultancy Woodbine states the introduction of the clearing mandate for many types of OTC derivatives will lead investors to review their options.
“Firms will adopt strategies that minimise the all-in cost of a transaction over its expected lifecycle,” wrote Sean Owens, director of fixed income at Woodbine and author of ‘Interest rate swap futures: Finally the right time’. “This will include execution-related cost as well as funding. We expect firms to reevaluate the criteria used in their hedging programmes and to more closely consider the costs and benefits between acceptable basis risk and the ‘perfect’ hedge.”
Standardised OTC derivatives – including a large proportion of the US$440 million IRS market – will be traded on venues and centrally cleared under the new rules in US’ Dodd-Frank Act and Europe’s European market infrastructure regulation. As the rules begin to take hold, Woodbine argues that tailored products like swaps will no longer be the most effective way to take a directional view on rates or swap spreads. IRS futures have more favourable initial margin treatment than traditional swaps and also benefit from increased netting capabilities and lower clearing costs. “While many see this as the futurization of the swaps markets, it is actually the reversal of the swap-ification of generic risk transfer,” said Owens. “As the clearing mandate phases-in (and subsequently the trading mandate), the costs involved will become tangible and begin to accrue.”
He added that IRS futures would likely be most popular among dealers trying to balance cleared swap risk positions at clearing houses, participants seeking to maximise netting offsets with other futures products, high-frequency trading and arbitrage firms, those wishing to operate under a single regulatory framework and smaller firms that may not have access to clearing services offered by futures commissions merchants.
However, swap futures growth may be inhibited by the cost of rolling a hedge forward every three months – which may mean their use is primarily favoured for short-term hedging – and a current lack of trading volumes and liquidity.
The consequences of swap futurization were discussed at a recent roundtable hosted by the Commodity Traders Futures Commission. Prospective operators of swap execution facility – new venues established by Dodd-Frank that will offering trading of OTC derivatives – stated the favourable margin treatment for swap futures is incompatible with exchanges’ marketing of the contacts as economic equivalents to swaps.
However, exchanges argued the regulatory regime for futures markets – in terms of pre- and post-trade transparency and clearing – mean a more favourable margin treatment compared to OTC derivatives products is justified.