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News: Putting Things Into Perspective | Swaps vs. Swap-Futures

04 April 2013 | Ben Larah

It looks as though some market participants could do with a couple of words of advice from Harry Enfield's Scousers: "Calm Down!" The Initial Margin (IM) calculation differences between swaps and swap-futures have already been covered in some depth on The OTC Space (see posts here and here). But, for convenience, here's a quick summary:

  • Cleared OTC IR Swaps will be subject to a 5 - 7 day holding period, depending on the clearing house, for IM calculations
  • Swap-futures will be subject to a 1 -2 day holding period, depending on product, for IM calculations

Arguments for and against the above treatment have ensued between the CFTC and futures exchanges, and the OTC markets. They culminated in Bloomberg LLP threatening legal action against the CFTC. According to Bloomberg:

"Bloomberg LP, the parent company of Bloomberg News, said the collateral rules are arbitrary and harm its plans to operate a swap-execution facility [SEF] ... Swaps that are converted to futures will “automatically be subject to a lower minimum liquidation time, which in turn will result in more favorable margin treatment,” Scalia said in the letter to the Commodity Futures Trading Commission. The different standards will drive business away from Bloomberg’s swap-execution facility, Scalia said.  The CFTC should stay the regulations, which set a five-day liquidation requirement for financial swaps compared with a one- day period for futures, Scalia said."

The sentiment that economically-equivalent contracts shouldn't be subject to such large IM differentials is not uncommon. But how overblown are the fears that swap-futures pose an existential threat to the swaps market? First, I question the claim that the existence of different IR derivative contracts, with different margining rules, will drive business away from one contract towards the other. One is making the assumption that there exists a fixed quantity of demand for interest-rate derivatives, and that every purchase of a swap-future represents a missed opportunity for a swap to be traded. This isn't necessarily true. Swap-futures may have opened the IR derivatives markets to new participants who had no prior trading activity in the swap markets. In such cases no business is being cannibalised. Furthermore, if we look at the market data since the introduction of CME deliverable swap-futures in December 2012, we have seen an increase in volume for both cleared and uncleared vanilla USD IR swaps, and we've also seen a significant increase in traded volume for swap-futures! There's no way of knowing whether each swap-futures purchase would have been a swap purchase, had the swap-futures market not been in existence, but we are empirically faced with increasing trading volumes in both products. Second, let's take a look at trading volumes throughout February 2013 for swaps vs. swap-futures, in terms of reference notional (please note that 1 CME swap-futures contract = USD 100,000 worth of reference swap notional):

Date (1) CME Cleared Swap-Futures Notional (USD) (2) Cleared & Uncleared IR Swap Notional (USD) Swap-Futures Notional Volume/IR Swap Notional Volume

1-Feb-13

282,700,000

48,565,955,300

0.5821%

4-Feb-13

144,300,000

34,561,880,000

0.4175%

5-Feb-13

127,500,000

32,236,995,000

0.3955%

6-Feb-13

259,000,000

46,856,347,644

0.5528%

7-Feb-13

238,600,000

33,321,812,311

0.7160%

8-Feb-13

149,400,000

31,161,510,000

0.4794%

11-Feb-13

121,100,000

22,517,005,000

0.5378%

12-Feb-13

115,100,000

38,275,467,045

0.3007%

13-Feb-13

165,900,000

44,267,735,005

0.3748%

14-Feb-13

172,100,000

48,167,943,291

0.3573%

15-Feb-13

236,000,000

33,098,200,110

0.7130%

19-Feb-13

148,700,000

38,907,610,000

0.3822%

20-Feb-13

277,600,000

45,493,050,000

0.6102%

21-Feb-13

223,900,000

45,307,812,302

0.4942%

22-Feb-13

765,000,000

70,933,270,000

1.0785%

25-Feb-13

389,000,000

43,515,286,366

0.8939%

26-Feb-13

236,300,000

55,521,402,344

0.4256%

27-Feb-13

157,800,000

43,264,170,000

0.3647%

28-Feb-13

647,600,000

40,236,975,667

1.6095%

  1. The data in the "CME Cleared Swap-Futures Notional" column was compiled from the CME's web-site here) and relates to their Deliverable Swap Future contracts, the composite volume of the 2, 5, 10 and 30 year contracts.
  2. The data in the "Cleared & Uncleared IR Swap Notional " column was obtained from the Clarus FT DDR Tool, which can be found here and relates to public OTC data reported in the US to DTCC only.
Look carefully at the bottom for the CME contracts in blue

 

As Joe Rennison in this Risk Magazine article (subs) points out, we're talking about a "drop in the ocean" when comparing swap-futures notional volumes to swap notional volumes. The right-hand column in the table shows that, on most trading days in February, the swap-futures trading volume was less than 1% of the swaps trading volume (and this is just for the vanilla fixed vs. floating swaps). But will this demand change over time? According to Will Rhode in a November 2012 Tabb Group report, swap-futures open interest could reach 3% of outstanding swap notional by mid-2014. We're still talking about a fraction of the volume here! To conclude, there is no reason to believe that the IR swap-futures market and the OTC IR swaps market cannot coexist side by side with each other, catering to different market participants for different purposes. End-users, who are largely exempt from mandatory clearing requirements, will prefer the OTC swap product because the payments can be customized to match their risk exposures. For these participants, trading swap-futures may create a degree of basis risk  which would need to be further hedged. At the same time, buy-side market participants will be attracted to swap-futures because of the IM capital relief compared to swaps and the more efficient trading mechanisms for swap-futures. To put my conclusion more succinctly: "Don't Panic!" (Captain Mainwaring) Ben L.


Comments

Reblogged this on Carl A R Weir's Blog.

Thanks Ben, very well explained and another of those fads hyped by the media and actually just an additional way to enter a hedging relationship.By the way "Don't Panic" is also a recurring theme at the "Hitchhiker's Guide to the Galaxy" by Douglas Adams... :)

Thanks for your feedback. Perhaps Douglas Adams's "Don't Panic" would have been more appropriate than Corporal Jones's (given that Jones was, in fact, panicking!):)

Interesting stats but things could quickly pick up in the next few years as it did in energy after the post enron regulatory change. Would be good to see a graph on the futures migration in energy trading. http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/dfsu...

A few comments:1. The race hasn't really begun fully whilst quite a few financial firms are still able to trade swaps bilaterally without mandatory clearing / bilateral margin mandated (i.e. still cheaper than Swapfutures).2. To take full advantage of swapfutures, a participant would want to have portfolio margining set up at CME. Not sure how many clearing member dealers have this and only the first client went live recently.3. On the credit piece, the latest proposal from ICE to offer futures on CDS spreads seems to indicate that there are some considerable problems (which I cannot offer insight to) with adopting an ERIS style approach to CDS products (mimicking the CDS economics through the life). Perhaps CDS lives therefore.4. On your figures I think we should monitor total swapfutures (both CME DSF and ERIS contracts) vs. only cleared swaps (at both LCH and CME - not sure if this is all showing in the DTCC ticker - given CME's rule 1001 thing and ET exemptions). I'm not sure if that makes the numbers significantly different but I think the ERIS contracts are a more direct threat to cleared IRS than DSF (at least with only short maturities / swap start dates tradable). 5. A swap risk market maker with no significant risk cleared at CME (or not yet able to portfolio margin swapfutures vs. IR futures or CME cleared IRS) will often pay more IM to take on a swapfutures position cleared at CME (2-day IM but without a readily available D2D hedge in the size needed) than an equivalent swap with a readily available dealer to dealer hedge at Swapclear (approx. zero net margin after netting the client trade with the D2D hedge). The question is when does the tipping point come where there enough client risk build up in both directions (fixed payer and fixed receiver) that there are D2D hedges readily available (either in CME IRS clearing or CME swapfutures clearing) and market makers provide liquidity to the swapfutures platforms on a routine basis and participants all have the requisite connectivity and portfolio margining infrastructure in place to work the new model....

Putting Things into Perspective, Comparing Swaps and Swap Futures