March 1, 2014

A Bright Future For Swapping Futures

While no one expects swaps futures to take over the OTC swaps market, a movement of 5 percent of the massive OTC swaps volume would be a huge win for futures market.

By Renee Caruthers

As market participants and observers wait to see what shape the over-the-counter swaps market will take in its transition to electronic trading, a corner of the futures market will be observing the OTC swaps transformation just as intently.

Introduced roughly a year ago to coincide with new OTC swaps mandates, swaps futures share some traits of swaps, but trade on futures exchanges, where they face less onerous regulations and can tap into the technological efficiencies of established trading and clearing platforms.

The current swaps futures products are interest rates instruments and are traded on the Chicago Mercantile Exchange and Eris Exchange, which has offices in New York and Chicago. The notional value of the combined total of the products trading on the two exchanges now exceeds $20 billion. To put that in perspective, the total notional value of interest rate swaps is estimated at more than $300 trillion, according to the International Swaps and Derivatives Association.

"One of the trends you have seen over the last couple of months is, open interest has been rising. Although it's coming from a small base, [it] has been increasing steadily. But it's still a minor fraction of overall OTC interest rate market," said Matt Simon, Tabb Group head of futures research.

For some, the enormity of the OTC swaps market is indicative of the size of the opportunity. While no one expects swaps futures to take over the OTC swaps market, a movement of 5 percent of the massive OTC swaps volumes into swaps futures would be a huge win for futures markets.

The products that fall into the swap futures class vary widely. The CME's deliverable swap futures trade as a futures, but as their name suggests, they deliver as swaps cleared at the CME if held through final settlement. The CME deliverable swap futures have standardized coupons that equate to what the industry calls Market Agreed Coupons. They offer two-year, five-year, 10-year and 30-year contracts, meaning the selection includes longer-dated contracts sometimes associated with the swaps market.

"We felt that our deliverable swap future would be more efficient for the marketplace from a capital margin and overall fee and cost perspective than swaps themselves," said Sean Tully, managing director of interest rate products for the CME. "For example, since it is a standardized swap contract, our deliverable swap future only requires a two-day margin period of risk. Under CFTC regulations, interest rate swaps, because they can be highly customized, have a five-day margin."

In addition, as swaps are moving toward electronic trading in a new environment, deliverable swap futures allow CME Group customers to leverage an established electronic trading environment, namely CME's Globex platform, for trading products with similarities to swaps.

"With the regulations around interest rate swaps changing, there is huge uncertainty about what the electronic landscape will look like and where the liquidity will be," Tully said. "We are leveraging the existing Globex platform to provide liquidity to the marketplace in a reliable manner in this time of uncertainty."

Approximately 25 to 30 percent of CME Group deliverable swap futures contracts are currently going to delivery as swaps, depending on the delivery month, according to Tully, suggesting participants are testing the products' delivery mechanism into swaps.