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Sam Priyadarshi, head of fixed income derivatives at Vanguard

Buy-side welcomes swap futures as OTC market undergoes structural reform

By James Williams – “At Vanguard we view swap futurisation as a positive development. It is another step in the trend towards convergence of how fixed income securities are traded electronically. Whether its swaps or swap futures, going forward you will have to trade them electronically,” says Sam Priyadarshi (pictured), head of fixed income derivatives at Vanguard.

Under US regulatory reforms, specifically with respect to the Dodd-Frank Act and CFTC regulation pertaining to swap clearing and the adoption of swap execution facilities (SEFs), the market structure of OTC swaps is going through a metamorphosis.
Asset managers must now decide how far to embrace swap futurisation by using products like the deliverable swap future launched by CME Group last December.
“Swap dealers are subject to higher capital requirement standards and if you want to trade swaps electronically then buy-side clients need to sign up with FCMs for swaps clearing, SEFs for swaps trading and credit hubs for pre-trade credit limit checks. So there’s a lot that we need to do now just to be able to trade an OTC swap,” adds Priyadarshi.
Conversely, swap futures offer standardisation, certainty of trading and the regulation is very clear. After all, people have been trading under it for decades in the futures markets without issue.
“The costs of executing and clearing swap futures are lower compared to OTC swaps. Their introduction is quite timely given the regulatory push to move OTC swaps into the cleared and SEF space,” says Priyadarshi.
Michael O’Brien, Director of Global Trading at Eaton Vance, one of America’s oldest investment management firms, is even more enthusiastic than Priyadarshi on the emergence of swap futures.
“I feel very strongly about the futurisation of the OTC space. The most liquid OTC instruments, which include interest rate swaps, are liquid enough to be listed on a central limit order book and should be for transparency, for ease of trading, and a lot of other reasons.
“I now trade Eris Exchange futures as well as CME Group’s DSF. They are cheaper to trade, easier to trade and they operate in a well-known regulatory environment. If you put swap futures alongside OTC swaps, the former wins on every level except one – which I think will change – and that’s liquidity. If you talk to the biggest asset managers in the industry there’s probably not enough liquidity right now,” states O’Brien.
“We can’t use the DSF contracts until they start trading in decent size. A large asset manager wanting to trade 10,000 DSF contracts cannot do so yet because the average daily trade volumes are not high enough. We will have to wait until the level of open interest increases.
“I think next year, when people will be forced to choose between electronic trading of swaps on SEFs and swap futures on DCMs, then we might start to see a pick-up in liquidity for swap futures,” comments Priyadarshi, who estimates that Vanguard could start using DSFs as early as Q1 2014.
Once more hedge funds and large asset managers gravitate towards swap futures it will become a virtuous circle. Everyone wants liquidity and the more of it there is in the DSF well, the more market participants will drink from it.
“Next year we will start using a combination of OTC swaps and these swap futures when the timing is right and if we are satisfied that the liquidity is there,” says Priyadarshi.
“I expect liquidity in swap futures to grow substantially once people realise how complicated and expensive SEFs will be. As more people get involved there will be enough liquidity to attract the biggest asset managers. But it won’t happen overnight,” notes O’Brien, who confirms that he has been trading the DSF contracts since they launched and are frequently used on a daily basis.
“The great thing about the block trade with the DSF is that the threshold is relatively low, roughly USD100million notional for the 10-year tenor I believe. A lot of the DSF contracts we trade are to hedge specific bonds, manage duration in the overall portfolio and take individual positions.”
There are, it seems, many advantages to swap futures that the buy-side community appreciates. The margin requirements are lower (2-day margin versus 5-day margin for cleared swaps), although Priyadarshi is right to point out that this is a temporary benefit because this only applies while the swap is trading as a DSF for the calendar quarter.
Once the contract is delivered it becomes a swap and the margin advantage drops off.
For real money accounts (as opposed to leveraged hedge funds) like those used by Eaton Vance, whose funds are registered as 40 Act funds and therefore comply with specific rules on leverage, the difference in margining is less of an issue but as O’Brien states: “Even in a reverse scenario, where the DSF required more initial margin than the OTC swap, I would still choose to trade the DSF.”
Choice of venue is another advantage. Participants know where to trade, whether it be CME, Eris Exchange, ICE. Compare that to OTC swaps, and going forward participants will have to comply not only with Dodd-Frank but also the individual rulebook of each SEF they choose.
Also, there are no reporting requirements for swap futures whereas cleared swaps have to be reported in near real-time by the swap dealer.
And then there are potential savings that customers can benefit from by margining their cleared swaps with other interest rate futures (e.g. Treasuries) and/or margining the DSF against those same futures (margining the DSF against cleared swaps is not yet available). This can help customers achieve up to 85 per cent margin savings because of the liquid benchmarks CME Group offers.
Says O’Brien: “Margin efficiency is certainly a competitive advantage for swap futures.  Minimising margin on trades with offsetting risk reduces cash drag on the portfolio and therefore contributes directly to returns.  In addition, it allows some trades to be economically viable that would otherwise not be if the full margin amount was posted on both sides of the trade.”
But there are disadvantages, the most critical being depth of liquidity.
“For instance, in the 10-year DSF open interest is around 41,000 contracts, which is very small and roughly USD4.1billion compared to approximately USD0.5trillion in OTC swaps traded daily. The average daily volume of 10-year DSFs is roughly 3,700 contracts which is the equivalent to USD370million whereas one large swap trade averages USD100-200million in notional,” observes Priyadarshi.
Then there’s the issue of standardisation versus customisation. As the DSF is a standardised contract available to trade on a quarterly basis in US dollars only, participants cannot use it for specific hedging activities.
“You can pick any re-set frequency (1-month LIBOR, 6-month LIBOR) and the currency in which to trade swaps, which you cannot do for swap futures. Consequently, the DSF can best be used for what we call ‘proxy hedging’ as opposed to bespoke hedging. If you want to hedge something with a 15-year duration you can’t use the 10-year or 30-year tenor DSF as you’d end up being under-hedged or over-hedged,” adds Priyadarshi.
To be clear, there is no suggestion that swap futures will suddenly replace the OTC market. Rather, they will form part of a basket of options for how portfolio managers choose to manage their rate exposure.
“Absolutely right. That will be not just our approach but the approach of all buy-side institutions,” confirms Priyadarshi.
“There’s still room for exponential growth in swap futures contracts but they will not replace OTC swaps. We’re registering with a SEF right now and appointing our futures commission merchant because we’re still going to use the OTC market,” says O’Brien, who goes on to say that in his view, one of the biggest advantages of standardisation is the fact that it allows for minimal line items.
“Taking off bilateral swaps is a painful process which will be eliminated in the new world of clearing but if you do a trade over five days you can still wind up with perhaps 25 line items to manage. That’s burdensome. With these standardised swap futures you’re in and out of contracts; it’s as easy as trading S&P futures.”
One development within the swap futures market that O’Brien says he would welcome is additional choice, particularly with respect to currencies.
“If CME could offer their DSF in euros I’d use it straight away. Both CME Group and Eris Exchange have said it is something they are looking at very seriously.”
Offering a final thought on the impact that swap futures could have in the marketplace, Priyadarshi comments: “Their introduction comes at a crucial juncture in the evolution of the market structure for swaps. With all the changes in margining, and the way banks view cleared and uncleared swaps in relation to their capital requirements under Basel III, swap futures have entered the market at a very opportune time.
“The fact that these swap futures now exist and can be traded in a standardised format is a welcome development.”
“The model is going to move to futures. CME is in the right spot,” concludes O’Brien. 

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