The dictionary defines the word “swap” as to change or interchange, to move, and even “to thrash,” a computer term meaning to move data into and out of the core rather than perform the useful computation. Regardless of which definition one chooses, each fits today’s evolving derivative marketplace quite well, as regulations have moved swaps on to the clearing stage.
The futures commission merchant (FCM) model that serves futures customers is being disrupted as it proves to be less profitable due to a low interest rate environment. At the same time, the traditional servicers of over-the-counter (OTC) swaps are also facing challenges of their own with increased costs and lower expected volumes in OTC swaps. Is the futurization of swaps the answer that could turn the tide for both? Could it help to transform the industry, increase volumes, provide a useful alternative contract to the buy-side, and invigorate the FCM business model?
Turning an OTC contract into a listed or “futurized” swap contract offers both benefits and drawbacks. The main drawback is the loss of flexibility to customize swaps on an individual basis. However, the key benefits include a less expensive margin treatment and greater efficiency, as well as a wider audience of firms to provide clearing of these contracts.
Futures contracts are more “standardized” *that is, more defined up front and more liquid* and exist in a more defined world of interconnected systems that is well understood by regulators and market participants alike.
Very different by nature
While listed and cleared OTC derivatives are converging in the new world of central clearing, their paths to this new environment are quite different. Ironically, the first futures contracts most likely started out as OTC transactions between two counterparties who recognized the mutual advantage of exchanging the price risk on a commodity. Fast-forward a few hundred years, and these same types of transactions are traded electronically on open exchanges, centrally cleared and highly regulated.
By comparison, OTC derivatives, specifically credit default swaps and interest rate swaps, are much newer to the financial ecosystem. Far greater in complexity, the arrival of OTC derivatives has been faster and had a much deeper impact on the financial industry than traditional listed derivatives.
Because these contracts are highly customized with no real limits on their size, it is difficult to understand the full impact of a major counterparty default. The results of this limitation are well known:
Dodd-Frank, central clearing, and a new world in which listed and OTC derivatives would be cleared alongside one another.
Although OTC and listed derivatives now live in the same clearinghouse, they are very different. Listed derivatives transactions are based on standardized, highly liquid exchange-defined products with predefined specifications that are traded in an open exchange. On the other hand, each OTC derivative transaction is bespoke and unique like a special brewed tea, with special features transacted in an exclusive deal between two counterparties.
OTC clearing requires a five-day VaR for initial margin, while futures use a one-two-day SPAN margin. Because the latter is better understood and more standardized, the amount charged for initial margin is less than that for OTC clearing.
Placing the clearing of an OTC derivative into the futures category, as in the case of interest rate swaps, could reduce margin requirements.
Potentially, any firm that is an FCM that already trades futures can offer these futurized swaps to new or existing clients.
Futurization could increase the number of FCMs offering these products at lower prices, which could produce happier customers and increased competition.
Ongoing change: are we ready?
Should the interest rate swap futures products attract large volumes, the cost of capital requirements to trade these futures that resemble interest rate swaps could become significantly lower than that of the equivalent cleared interest rate swaps. If early examples are followed by other exchanges that introduce new futures products designed to bring similar economic benefits as equivalent OTC derivative contracts, but with lower capital requirements and subject to fewer regulations, this could lead to the migration of OTCD business to the futures world.
It will be interesting to see if the CFTC takes action over the coming months to try to level the playing field between economically equivalent futures and swaps with respect to block trade sizes, margin and other requirements.