In the last several months, a new trend has taken shape in the migration of the U.S. over-the-counter derivatives markets towards electronic trading and central clearing. As the regulatory regime created by the Dodd-Frank Act has taken shape, some market participants have grown alarmed by the complexity and cost of compliance and have turned instead to the futures markets in search of a simpler and more cost-effective alternative to cleared swaps. In energy, a large part of the North American natural gas and electric power market was converted from swaps to futures almost overnight in mid-October, while in the interest rate sector, two exchanges—CME Group and Eris Exchange—have begun offering futures contracts designed to replicate plain vanilla interest rate swaps.
The trend is expected to widen in the coming months. IntercontinentalExchange plans to offer credit index futures in the first quarter, and Singapore Exchange plans to list a set of commodity futures that will be economically equivalent to the commodity swaps that it clears through its AsiaClear facility. In the case of SGX, the exchange has made it clear that the "futurization" of its swaps is aimed at addressing the needs of market participants affected by Dodd-Frank, a sign that the impact of the trend is extending beyond the U.S.
The main driving force in energy, according to exchange officials, was a desire by market participants to avoid certain Dodd-Frank rules, notably swap dealer registration, swap reporting requirements, and the extra-territorial impact of U.S. regulation. In interest rates, the new swap futures have only just begun trading, but it appears that significantly lower margin requirements will be the biggest attraction. In credit, ICE cites the potential for attracting new participants to the credit default swaps market and restoring some of the volume lost since the collapse of Lehman Brothers.
Policymakers in Washington have taken notice. The Commodity Futures Trading Commission is planning to hold a public meeting in the coming weeks to examine the trend and consider its implications for several pending rules that will affect the trading of both swaps and futures. That meeting is likely to focus on the energy markets, where the "flight to futures" effect has been most noticeable. It will also focus on the complaints of inter-dealer brokers and others that the new regulatory regime has unfairly tilted the playing field against swap market participants. One hot topic will be the rules for swap execution facilities, a new type of venue created by Dodd-Frank. The CFTC has not yet finalized its SEF rules, and a number of companies are eager to register as SEFs and establish their trading facilities in competition with futures exchanges and the new swap futures contracts.
Complaints about Regulatory Arbitrage
At a Congressional hearing in December, a coalition of interdealer brokers and swap trading venues complained that the unequal playing field created by the CFTC's Dodd-Frank rules is "threatening to strangle" the U.S. swap market in favor of the futures market. The hearing was organized by Representative Scott Garrett (R-N.J.), the chairman of the capital markets subcommittee of the House Financial Services Committee.
"After nearly two and a half years of rulemaking, the CFTC's cumulative approach to swaps regulation has imposed such high costs on the industry that the U.S. swaps market is on the verge of becoming too costly and too regulated—particularly as compared with futures—to be a viable means for end-users to hedge and manage their financing risk," said the coalition, which includes firms such as Bloomberg, GFI Group, ICAP, Parity Energy, Thomson Reuters, Tradeweb and Tradition.
At the request of CFTC Commissioner Scott O'Malia, the CFTC is planning to hold a staff roundtable discussion in late January or early February on the futurization trend. O'Malia, a Republican who worked in the energy sector before joining the agency, said in a November speech that such a discussion would help in understanding why firms opted to move out of the energy swaps market in October. He also said a roundtable would help the agency examine how its rules might affect the success or failure of SEFs.
Hanging in the balance are several important rules related to trading that will affect the choice between swaps and futures. The CFTC is now considering a package of proposed Dodd-Frank rules that will determine how swaps are traded on swap execution facilities and the ability of futures exchanges to set block trade thresholds. The package also includes rules relating to the "made available for trade" provision in the Dodd-Frank Act as well as a proposed amendment to Core Principle 9 that would affect the amount of trading that futures exchanges can conduct through off-exchange mechanisms such as block trades and exchange-for-swaps.
CME and ICE Futurize Energy Swaps
The starting gun for the futurization trend came in mid-October, when CME and ICE, the two leading markets for energy swaps in North America, changed the way their markets operate just ahead of a key regulatory deadline. According to officials at both exchanges, many participants in the energy swaps market, especially commercial participants, were worried about the impact of new rules that were set to take effect on Oct. 12. In particular, they did not want to be classified as swap dealers, which would require them to comply with a host of regulatory requirements that go with swap dealer status. The exchanges also commented that a number of non-U.S. market participants were worried about the extra-territorial effect of the new swaps rules, and preferred the familiarity of the futures regulatory environment.
"Given the complexity of the new swaps regulation regime in the United States, customers uniformly agreed that futures markets best served their hedging and risk management needs in the energy and commodity space, allowing them to operate in a highly regulated regime that they know and understand," Jeff Sprecher, ICE's chief executive officer, said in a Nov. 5 conference call with analysts and investors.
In the case of ICE, approximately 800 energy contracts that previously traded as over-the-counter swaps were listed on ICE's futures exchanges in London and New York and made available for trading on Oct. 15. The existing open interest was converted into futures over the weekend of Oct. 13-14, and ICE's customers are now trading these products as futures.
Measuring the scale of the transition is difficult because ICE does not disclose the volume of trading in its OTC markets. The statistics for its futures markets show, however, that a significant amount of trading has taken place in the new swap futures since the conversion. From mid-October to the end of December, the exchange recorded volume of 59.6 million natural gas futures and options and 29.2 million power futures and options—all of which had been traded as OTC swaps and options prior to Oct. 15.
In the case of CME, the change mainly affected the method of trading, with a large percentage of its Clearport volume executed via block trade rather than traded off-exchange and then submitted for clearing via the exchange-for-swaps mechanism. Approximately 500 contracts were relisted as futures and made available for trading on CME's Globex platform. No conversion of open interest was necessary because Clearport transactions have been converted into futures via the clearing process since the facility was launched 12 years ago.
Initially CME's volume was affected by confusion about the regulatory status of its contracts. CME Executive Chairman Terry Duffy commented on Oct. 25 that Clearport volume dropped off in the two weeks after Oct. 12, falling from 400,000 to 250,000 contracts per day. He noted, however, that volumes began coming back as market participants adjusted to the change and in response to regulatory relief provided by the CFTC that gave brokers and traders more time to comply with the new regulations.
One issue affecting both exchanges is that these trades are now subject to traditional futures rules and regulations such as position limits and block trade rules. Several exchange officials and industry executives noted that many of the trades that previously were done over the counter are now being executed as block trades. While that gives the firms involved in the trade more flexibility on how the trade is negotiated, it means that the firms must comply with certain restrictions set by the exchanges. For example, block trades must be above a minimum size threshold, and the trades are reported to the larger market within a short period of time, usually 5-15 minutes after the trade details are submitted to the exchange. There are also restrictions on trading while a block is being negotiated, which could be problematic in relatively illiquid markets.
Healthy Start for CME Interest Rate Swap Futures
Meanwhile, in the interest rate sector, all eyes are on CME's new deliverable interest rate swap futures. In contrast to the energy markets, the goal here was not to convert existing contracts but rather to offer a new alternative. CME developed the contract in close consultation with leading institutions on both the buy-side and the sell-side, and when it launched the contract in early December, it had strong support from major swap dealers. Citi, Credit Suisse, Goldman Sachs and Morgan Stanley all agreed to act as liquidity providers, and more than a dozen banks signed up to provide execution for block trades.
At expiration, the contracts settle with physical delivery of the underlying swap. In effect, the CME contract is the equivalent of a forward-starting swap that initially trades as a future but can be converted into a cleared swap at expiration. The contracts come in four benchmark maturities—2, 5, 10 and 30 years—and have standardized quarterly dates and fixed rates.
One key feature of the new contract is that the margin requirement is based on a two-day value-at-risk methodology. The margin for cleared swaps, in contrast, is based on a five-day value-at-risk methodology. According to CME, that equates to a significant reduction in margin requirements for equivalent positions, in some cases more than 60%. CME also offers margin reductions for customers that have offsetting positions in other interest rate products. Currently the deliverable swap futures can benefit from portfolio margining with other futures, notably Treasury and Eurodollar futures, but CME expects that by June they can be combined with cleared OTC interest rate swaps as well.
Some users may be reluctant to use the new swap futures out of concern that the lack of customization will create accounting issues. Several market participants commented that corporate hedgers need a nearly exact match to their interest rate exposure in order to qualify for hedge accounting. Using a standardized contract may be less expensive in terms of margin, but a mismatch on duration would lead to unwanted gains and losses in financial results.
In the first two weeks after the Dec. 3 launch, 19,748 contracts were traded, including one block trade of 2,000 trades, and open interest had risen to 6,275 contracts. Volume slowed over the end-of-year holidays, but interest is expected to pick up as market participants become more familiar with the new contracts and consider their merits relative to cleared OTC swaps.
Morgan Stanley Backs Eris Swap Futures
While CME's launch attracted considerable attention in the interest rate markets, market participants are also taking an interest in a start-up called Eris Exchange. Eris was established in 2010 by five Chicago trading firms in anticipation of the migration of the over-the-counter swaps market to electronic trading and central clearing. Eris offers two types of contracts: standards, which are forward-starting contracts with pre-determined rates and dates; and flex contracts, which can be defined with any start or end date and offer more flexibility on rates. A key feature of both types of contracts is that they include "price alignment interest," which is designed to replicate the interest payments on collateral posted against a swap. According to Eris, this allows its contracts to replicate the cash flows on an interest rate swap in a much more precise way than traditional interest rate futures.
Eris won a key vote of confidence in December, when Morgan Stanley said it would make an equity investment in the exchange and act as a market-maker for its interest rate swap futures. The bank also will take a seat on the exchange's board of directors as part of the deal, the terms of which were not disclosed. In announcing the agreement, Morgan Stanley said that it believes Eris and its contracts will provide the firm's clients with "flexible alternatives" to traditional OTC interest rate swaps.
Eris also has succeeded in winning over several major clearing firms. The exchange recently listed Barclays and Citi, two big players in OTC swaps clearing, as clearing members, joining ABN Amro, Bank of America Merrill Lynch, BNP Paribas, BNY Mellon, Newedge and State Street.
The standard interest rate swap futures, which were rolled out in December, have significantly lower margin requirements than cleared interest rate swaps. The margin requirements are based on a two-day liquidation horizon, versus five days for cleared swaps, and Eris estimates that this will reduce margins by 40% to 80%. That is an important issue for institutional investors that will be looking for ways to reduce their need for collateral when mandatory clearing takes effect in the U.S. later this year.
The flex contracts, on the other hand, have five-day VaR margins, the same as cleared swaps. The advantage is that they can be tailored to the terms desired by a customer. That is a key issue for corporate hedgers that need to make sure that their derivatives exactly offset their interest rate risk in order to qualify for hedge accounting.
Eris officials say their contracts also will be attractive to firms that trade spreads between different types of interest rate products. Eris announced in December that it is working with Trading Technologies, a software vendor widely used in the futures industry, to make its contracts available via TT's trading platforms during the first quarter. Eris officials highlighted the potential to use TT's autospreader tool to trade "invoice spreads," i.e., a trade that combines interest rate swaps with Treasury futures of a similar size and tenor. This type of trade is often used by hedge funds to express views on the direction of swap spreads, according to Mike Riddle, chief operating officer at Eris. Speaking with potential users during a December webinar co-hosted with TT, Riddle said invoice spreads currently account for 10% to 20% of the trading activity in the U.S. dollar-denominated interest rate swap market.
ICE to Launch Credit Futures
In the credit sector, ICE is preparing to launch CDS index futures in the first quarter. The exchange signed a licensing agreement in October with Markit that will allow the exchange to use Markit's benchmark North American and European corporate credit default swap indices as the basis for the new futures contracts.
During a Nov. 5 conference call with investors, ICE officials conceded that credit futures have been launched before without success but said the prospects for credit futures are better now than ever before. Sprecher said one reason is that volume in the CDS market has been shrinking since the collapse of Lehman and market participants view the introduction of CDS futures as a way to increase participation in the market.
"We have seen where a well-designed futures contract helps stimulate growth in underlying markets," Sprecher commented. "We're spending a lot of time with major dealers and with major buy-side participants and we're laying out a number of different alternatives that we have in mind on how we could evolve and unfold the market. So we're getting a lot of balanced input from the client base, and there is definitely interest and excitement about putting a product out there that will help grow volumes."
SGX Futurizes Commodity Swaps
Starting in February, Singapore Exchange plans to modify its AsiaClear service to provide its customers the choice of clearing OTC transactions as swaps or futures. SGX officials said the move will help international customers that are impacted by the new regulatory environment for OTC derivatives.
"We are committed to helping our customers throughout Asia, Europe and the U.S. navigate the complexity of rapidly evolving risk management and regulatory requirements," Michael Syn, the exchange's head of derivatives, said in a Jan. 10 statement. "Customers using our unique SGX AsiaClear service are free to choose transaction modes which best fit their needs while clearing through a single venue."
SGX has provided clearing for bilateral trades in certain commodity swaps via AsiaClear for a number of years. Much like the Clearport facility developed by CME, contracts are not traded on the exchange but instead submitted to SGX for clearing. It has been especially successful in the iron ore market, with a market share estimated at around 90%. Last year it cleared 108.9 million tonnes of iron ore swaps, more than double the previous year.
The exchange plans to start with 12 futures contracts based on iron ore, freight rates, fuel oil, kerosene and certain other oil products. The contract specifications are similar to the corresponding swaps, the settlement prices and expiry dates are the same, and the risk management treatment is the same once the products have been cleared.