SEFs Compress Trades
As essentially brand-new entities in the often-complex business of derivatives trading, swap execution facilities are well-served to make the end-user experience as streamlined as possible. For interest rate swaps, one way to simplify is via compression, which eliminates offsetting trades, reducing risk and cost and freeing up available credit in the process.
“Compression is generally understood to be a process in which dealers tear up trades that are equal and offsetting in order to reduce the number of trades in the system,” said Luke Zubrod, director of risk and regulatory advisory at Chatham Financial, a financial-advisory and technology firm. “This is a ‘risk mitigation’ measure, rather than a trading mechanism.”
Tradeweb’s TW SEF completed its first compression transaction of cleared derivatives trades in November 2013, and more than $850 billion in compression trades have since executed on the trading platform.
“Compression is a critical piece of functionality that enables balance-sheet optimization for buy-side participants,” said Chris Amen, head of U.S. institutional rates markets at Tradeweb. “It allows traders and portfolio managers to take a significant number of trades and reduce that either into a net-zero position or a single line item. Their ability to put on swaps, take off swaps, and manage their portfolios via our compression platform, drives an enhanced user experience when trading derivatives electronically.”
Market agreed coupon (MAC) swaps were introduced by Sifma’s Asset Management Group, in conjunction with the International Swaps and Derivatives Association, as a new interest rate swap contract structure with pre-defined terms. The aim of the voluntary contracts is to promote liquidity and enhance transparency in the interest rate swaps market. In the SEF space, Tradeweb and Bloomberg have been most active in compressing IRS trades.
“A MAC swap is a swap in which the coupon has been fixed by an industry association,” said Sam Priyadarshi, head of fixed income derivatives at Vanguard. “For example, for the 10-year market agreed coupon swap, Sifma has announced that it will have a 2% coupon, fixed rate. Since the fixed rate is known, it trades like a bond and the bid and offer are quoted in terms of dollars, not in terms of the fixed rate.”
Traditional ‘plain vanilla’ swaps with on-market rates won’t net or collapse into a single line item at the clearing house, but MAC swaps, by virtue of standardized dates and a fixed, standardized rate, are fungible and will collapse into a single line item.
For instance, if a 10-year, 3% coupon MAC swap was entered into on March 1, it could be sold two weeks later and be removed as a line item from the trading book. But if a 10-year plain-vanilla swap were entered into on March 1 and sold several months later, the seller would still have the obligations from both the original purchase and the subsequent sale of that swap, until the swap expires.
“The March MAC swaps remains on the SEF from mid-December until mid-March. so in mid-March, (when) I’m going to move to the June MAC swaps, I just have to do one roll,” said Priyadarshi. “The advantage is I have full liquidity and I have only one line item in my portfolio.”
Since their inception, trading in MAC swaps gradually increased to represent about 10% of total swap trading volume on Tradeweb as of the fourth quarter of 2014.
It may be a challenge to significantly ramp up that number. Zubrod of Chatham Financial said some clients have been slow to warm up to MAC swaps because they don’t like the idea of trading a swap based on value rather than rate, and there is some uncertainty regarding the taxation of MAC swaps.
Also, swap futures traded on Eris Exchange and CME “get you roughly the same economic exposure” with less complexity, said Michael O’Brien, director of global trading at Boston-based Eaton Vance, which manages $296 billion. O’Brien said he trades some MAC swaps, but more swap futures.
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