By Douwe Miedema
WASHINGTON Dec 10 The latest challenge to
investment banks' iron grip on finance has its unlikely roots in
Since the mid-1980s, Wall Street has built a $650 trillion
playground for speculators using financial instruments called
swaps. These were originally designed to insure companies
against financial risks.
Now, investors are shifting away from swaps into similar
contracts called futures, which farmers have used for centuries
to protect the value of their crops and livestock from sudden
drops in market price].
Both futures and swaps contracts are bets on anything from
interest rates to foreign exchange levels or commodity prices.
Technically, they are different, but economically they can
function in much the same way.
Swaps, dominated by investment banks and long unregulated,
risk becoming more expensive to use than futures now that
watchdogs are clamping down on the former, blamed by critics for
exacerbating the 2008 financial crisis.
Philip Obazee, the head of swaps and futures trading at
asset manager Delaware Investments, has been weighing up the
merits of the two different types of derivative.
He looks favourably at last week's launch of a new product
by the CME Group Inc, the world's largest futures
exchange, which promises clients the same characteristics as
swaps at a far lower cost.
"I am watching it very carefully," he said, speaking on the
telephone from a Philadelphia trading floor.
"Am I going to use it? Definitely. Am I using it on day one
or two? No. I want to see how the market develops."
If futures start replacing swaps in earnest, it would be a
salient example of how the U.S. Dodd-Frank overhaul of Wall
Street - and similar efforts in Europe and Asia - are starting
to reshape the competitive landscape.
Investment banks such as JP Morgan, Citi and
Bank of America would see one of their most lucrative
products hurt, while futures exchanges gain.
Officials from these three banks were not immediately
available for comment.
The biggest threat is for the more standardised types of
swaps, which are easiest to replace by futures. Bankers say
there will always be the need from customers for more complex
swaps, which rarely trade and have a high value.
Futures have a venerable history. Trading was big enough in
1531 for the Flemish city of Antwerp to build an exchange for
early forms of the contract. London and Amsterdam followed suit
in 1571 and 1611 respectively.
The CME's precursors have been trading such contracts since
around 1850, and the practice soon became regulated. The market
is now overseen by the Commodity Futures Trading Commission
(CFTC) - the top U.S. derivatives regulator.
The Dodd-Frank overhaul of Wall Street gave the CFTC massive
new powers to regulate swaps trading, which takes place out of
sight from regulators, mostly in bilateral contacts between
buyers and sellers over the phone.
New rules will bring most swap trading onto exchange-like
platforms, with clearing houses standing between buyers and
sellers to shield against default. Trading data will become
public in central repositories.
The CME's new product - called swap futures - is a targeted
attack to lure clients because they worry about the impact of
all those new rules, in particular the costly need for higher
safety margins in swaps as opposed to futures.
"These contracts require half the margin of cleared interest
rate swaps," said Sean Tully, CME's global head of interest rate
products. "We're trying to provide the most efficient solution
for the market under the new regulations."
Another futures platform, Eris Exchange, has launched a
similar product, while the Intercontinental Exchange is
replacing certain types of swaps with futures contracts. All
cite the new rules as the reason.
The stakes for the banks are high. They provide no insight
into how profitable swaps trading is. The units that include the
business are large revenue drivers.
"In interest rate swaps, the core suppliers of liquidity
have been the major banks. Therefore, they dictated the (cost of
the swap for the user) between themselves," said one industry
participant, asking not to be identified.
"If that goes across to futures markets, they could be
challenged by the larger funds (asset managers). The banks are
reluctant to watch this happen," he said.
BANKS FIGHT BACK
Defenders of swaps say that they provide more flexibility.
For instance, a capital goods manufacturer with an order book
stretching decades ahead would struggle to hedge all its
currency and interest rate risk by using futures.
"Futures are like (what) Henry Ford said about the model-T,
you can get any colour you want as long as it is black," said
Craig Pirrong, a professor of finance at the University of
Houston who has published about derivatives.
Moreover, accounting rules stand in the way of using futures
for those companies who need to accurately match their hedges
with the value of assets to avoid losses.
And because of exemptions, there is less of an advantage
into moving over to futures for risk hedgers than for financial
investors, the large funds who invest in derivatives purely for
Still, hedgers - or end-users - make up only 10 percent of
the market. If the big financial speculators moved into futures,
the swaps industry would be under serious threat.
A Risk magazine survey of 10 big asset managers who invest
in derivatives - including BlackRock, Alliance Bernstein, Eaton
Vance and Vanguard - found in October that all these
firms are considering shifting into futures.
Already, investment banks are positioning to fight back if
that happens: Citi, Credit Suisse, Goldman Sachs
and Morgan Stanley will function as market makers
in the CME's new product.
Moreover, many large investment banks are among the world's
top futures brokers. But the sore point is that futures are a
lot less profitable than swaps, in part because futures have a
greater pricing transparency.
And while futures may be a crude tool now, providers will
make sure that customers will get more choice later.
"It is possible, if not even probable, that the futures
world will make steady progress against making their products
more and more customizable," said Luke Zubrod at Chatham
Financial, a consultancy firm.
If he is right, more speculators will start using futures.
And that can only mean bad news for banks.
"If the liquidity ... does start to go into futures market,
then yes, the margin pressure for standardized swaps will be
immense," the industry participant said.