By James Williams – “We’ve seen nearly continuous growth in open interest since we first launched the Deliverable Swap Future in December last year,” comments Sean Tully, head of interest rate and OTC products at CME Group.
Major changes are underway in the financial industry, not least of which is the electronification of the derivatives markets and the introduction of Swap Execution Facilities under the Dodd-Frank Act.
With CFTC regulation requiring major swap dealers, hedge funds, and other asset managers and institutional investors to register and commence clearing of their swap contracts, there has been an unavoidable push towards greater transparency. Part of this narrative is another new term – ‘swap optimisation’.
It is against this backdrop that CME Group, at the end of last year, launched a new product, the Deliverable Swap Future, to meet the needs of swap traders (both buy-side and sell-side).
“The advent of having to clear interest rate swaps creates more onerous margining requirements for buy-side firms and therefore massively increases costs. In addition, we’re going to have the SEF requirements and eventually the made-available-for-trade requirements meaning certain plain vanilla swaps will have to trade electronically on SEFs.
“Increasing costs both on the execution side and clearing side for swaps meant that there was an opportunity to offer a standardised swap in a futures format that offers all the convenience of a futures contract. That’s why we created the Deliverable Swap Future,” explains Tully.
Since the start of the year, as the number of registered swap participants has climbed so has the level of open interest in the DSF, recording continuous growth from 10,000 contracts in January to a peak of 95,000 contracts in September. Average daily volumes in September also spiked to a record 10,000 contracts, all of which suggests that uptake in this innovative product is on the rise.
“It’s the second most successful interest rate futures launch we’ve ever had. It’s still only scratching the surface of the overall swaps market but it offers a lot of benefits,” says Tully.
Mechanics of the Deliverable Swap Future
Unlike an OTC swap, which offers full customisation in terms of contract duration, size, and coupon, the Deliverable Swap Future is a standardised contract. It is available in 2-year, 5-year, 10-year and 30-year durations across the interest rate curve and, currently, can only be traded in US dollars, although Tully points out that additional currencies (EUR, GBP) and durations (7-year, 15-year) will be offered over time as demand builds.
Each of the four benchmark maturities can be traded in two standardised contracts: December ’13 and March ’14. One of the major benefits of trading the DSF is that because of the standard dates and coupons it only requires the end-user to post 2-day margin period of risk as compared to 5-day margin period of risk for cleared OTC swaps and 10-day margin period of risk for non-cleared OTC swaps.
The DSF is not a panacea for managing rate exposure, however. Rather, it will likely become a key choice in a menu of options used by hedge funders and other buy-side institutions depending on how a portfolio is traded. In other words, CME Group, by creating the Deliverable Swap Future, is better able to provide choice to its customers. Some will continue to use cleared swaps only, others will use a mix of cleared swaps, swap futures and even some degree of exchange-traded futures.
“If customers want customised dates, coupons etc, they can continue to trade over the counter and clear those trades with us. (We cleared USD110billion of Interest Rate Swaps daily in September). They can also gain significant benefits using portfolio margining. For example, a hedge fund doing relative value trades between CME futures and swaps cleared at CME can achieve greater efficiencies and potentially 85 per cent margin savings. If they use the DSF to trade against a CME Treasury future in an Exchange for Risk (EFR) swap spread, those savings could be even higher. We’re trying to create the most optimal platform for our customers to manage their risk,” explains Tully.
Margin compression is a clear benefit. The 2-year deliverable swap future has an initial margin of 0.20 per cent compared to 0.65 per cent for the equivalent OTC contract. For the 30-year swap, the difference is 4 per cent compared to 8.25 per cent.
Then there are fee savings to consider. OTC clearing members are now applying additional charges for clearing swaps to the tune of 25 to 35 basis points of initial margin. This is on top of the higher initial margin required. No such fees apply in the futures market.
“Some market participants have told us there is a floor on the minimum monthly charge for clearing swaps; if you are a low volume swap trader that floor might be quite uneconomic. Trading futures eliminates that floor cost that now exists in the swaps market,” adds Tully.
As mentioned, all four maturities are deliverable in two contracts that follow the quarterly IMM cycle: December ’13 and March ’14. Anyone who trades one of these swap futures is locked in to either paying or receiving on an underlying IRS with a set coupon. Just like any other futures contract, users can choose to either trade in and out of the contracts without ever taking delivery, or hold the contract to final settlement.
“If, at the close of business on the Monday preceding the IMM Wednesday, the customer still has an open position in our December swap future, for example, they have to have the ability to take delivery of an actual OTC swap cleared at CME Group
“The customer will then have to follow the margining and execution rules of an interest rate swap,” says Tully, who continues:
“The difference between the swap future and an OTC swap is that you’re trading it as a futures contract and the price of that futures contract will represent the net present value of the swap that you would be taking delivery of on the IMM Wednesday date. Also, unlike having to trade swaps on one the new SEFs under CFTC regulation, customers that use our swap futures can select a number of different futures execution venues.”
These venues include: CME Globex (its e-trading platform for interest rate futures), in the pit via open outcry – both of which use a centralised order book – or OTC where block trades can be privately negotiated.
With respect to liquidity, the average bid-offer spread on a USD70million 2-year swap future is 0.9 basis points on Globex. For block liquidity, the bid-offer spread on the 2-year (USD300million minimum threshold) may be 0.6 basis points, on the 5-year (USD150million) it is 0.5 basis points, on the 10-year (USD100million) it is 0.4 basis points, and on the 30-year (USD50million) it is 0.4 basis points.
Customisation versus Standardisation
Aside from market participants needing to wait for liquidity to deepen in these new swap futures contracts, one of the ongoing points of discussion is how effective they can be relative to OTC swaps when it comes to hedging interest rate risk. There’s no doubt that OTC clearing requires a change in mindset among hedge funders. But on the issue of customisation, Tully believes that the flipside to the argument is that until now participants have had little choice other than to do it bilateral, par coupon swaps and that the end result is a complex swap book with hundreds, potentially thousands, of line positions.
“Take a macro-orientated hedge fund for example. Let’s say they want to pay fixed in 10-year swaps for a couple of weeks and then switch to receive fixed in 10-year swaps. The result is that they wind up with a large set of customised swaps with different coupons. And whilst it can reduce their operational risk, unwinding each of those positions can be time consuming and costly.
“A lot of managers wanted a standardised solution but until now it wasn’t readily in the market in a liquid format. Now they can sell the 10-year swap future over a couple of weeks, then reverse the position if needed and buy the swap future, and at the end of the trading period there are no individual line items to clean up because everything is done in a standardised format.”
This is a clear advantage to dealers because it reduces the notional outstanding, a major fillip at a time when banks are having to strengthen their capital ratios under Basel III.
Clarifying the tax issue
Tully clears up a final point on the current confusion that exists over whether taking delivery of an OTC swap at CME Group could be perceived as a loan and therefore subject to tax.
“In light of IRS guidance in similar circumstances, we believe the better view is that the upfront payment required by the clearing house at delivery should not be treated as a loan. However, we will continue to work with the industry and other parties to obtain guidance providing greater clarity.”
Nonetheless, for participants who are concerned, there are choices to address this. The first is to avoid taking delivery of the contract. Most participants will choose to roll the contract into the next quarter just as they do with any other type of futures contract. Right now, that would involve selling the December contract and rolling into the March ’14 contract.
“The second option is that we have the ability to list a second coupon for every delivery month. If, for some reason, the current coupon for December contract moved significantly ‘out of the money’, if there were demand for an ‘at the money’ contract to be listed with a different coupon we could do that and participants could then roll out of the ‘out of the money’ coupon into the new ‘at the money’ coupon.”