November 30, 2012 / 7:00 PM / in 5 years

CME to launch interest rate swap futures

NEW YORK, Nov 29 (IFR) - CME Group Inc is planning on Monday to launch a new futures contract tied to interest rate swaps, taking advantage of a new regulatory landscape for an exchange-traded product.

The financial regulations known as Dodd-Frank have made a push for over-the-counter derivatives such as plain vanilla interest rate swaps to be traded on exchanges and through central counterparties and to be reported to trade repositories.

If over-the-counter (OTC) contracts are not cleared by a clearinghouse, they could be subject to higher capital requirements. That, along with the margin that is required to be posted when trading a futures contract or a swap, can make such trades prohibitively expensive for some end-users.

That’s where interest rate swap futures come in. The product is standardized, deliverable and references an interest rate swap as an underlying with two-year, five-year, 10-year and 30-year maturities as benchmarks. Touted as efficient and cost-effective, the forward contracts are guaranteed by the CME.

The cost efficiencies can be seen in the difference in margin requirements between “plain vanilla” cleared interest rate swaps and the new swaps futures. CME says the new contracts offer margin savings between 45% to 73.5% over that of cleared IRS and futures.

The difference in margin rates has to do with the perception of worst-case risk scenarios, according to George Goncalves, Head of Rates Strategy, Americas at Nomura.

This perception stems from the staggered start dates, maturity dates and other unique characteristics of OTC products which are perceived as taking longer -- up to about five days -- to exit in case of market distress, he said in a note. By comparison, the exit from swaps futures takes just two days.

But Goncalves says while the standardized contracts could appeal to some participants who lack access to the OTC swap markets, the “capital efficiency” aspect may be overstated.

“For a well-hedged OTC book, the netting amongst various positions and the resulting risk reduction could decrease the total collateral requirements,” he said.

Margin savings aside, the standardization of the contract will make it easier to clear with a clearinghouse, however, it will also reduce its adaptability and the uniqueness seen in an OTC swap.

“The OTC market is far more flexible in terms of dates, tenors and coupon,” said a swaps trader.

“The problem (with IRS futures) is that by their very nature of IMM dates, then they are too rigid: just four quarterly dates per annum, and of designated maturities and priced using pre-determined coupons, ” he said.

Most futures and options use IMM, or International Monetary Market, dates as expiry with termination occurring on the third Wednesday of March, June, September and December.

In spite of a perceived lack of flexibility, the swaps trader said the IRS futures may be useful.

“In terms of a ‘quick and dirty’ hedge for active swap books, then they may well prove useful, especially in light of their effectiveness (cheapness?) margin/collateral wise.”

“However I remain unconvinced, as the bond and note futures currently serve as the proxy hedge to swappers, which still provide ease of execution and solid liquidity,” he said.

The trader was referring to the deliverability of IRS futures as many are unlikely to be carried to maturity as it exposes the user to an increase in margin rates.

The launch date is December 3. CME Group says it has a handful of market-makers including Citigroup, Goldman Sachs and Morgan Stanley committed to the product.

However, one futures trader said he has seen “very little enquiry so far in IRS futures.” His “gut” feeling is that “they are too similar to the existing ‘swapnote’ futures which have been up and running for a long while now, yet still flounder near the bottom of the daily volume tables.”

Swapnote futures are also exchange-based, denominated in two-year, five-year and 10-year maturities, as a method of managing interest rate risk via bond futures tied to interest rate swaps.

Nomura’s Goncalves said this is not the first time CME has attempted to launch IRS futures. Back in 2009, a similar swaps future was introduced, “but the product was not particularly well-received,” he said.

This was due to the difference between the futures product and OTC product which could have prompted the former to “cannibalize” the latter.

Now however, Goncalves says the regulatory environment favors these futures products.

Time will tell. For the swaps trader, he maintains most of the swaps market will “go on screen” in terms of execution, but perhaps not necessarily through a fixed futures contract.

“The end-users of swap markets are financial institutions and corporates who want to match out their cashflows and exposures, which are most easily and explicitly achievable via the OTC market, ” he said.

“In the end, I imagine it will be more akin to matched betting sites, or if you prefer, matched shopping sites (such as eBay),” he said

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