Swap Futures Not an Oxymoron

Terry Flanagan

The fungible nature of over-the-counter swaps and exchange-listed futures is coming into sharp relief with the onset of mandatory clearing regulations on both sides of the Atlantic.

In the United States, swap dealers, major swap participants and private funds active in the swaps market have all been required, from March 11, to begin clearing certain index credit default swaps and interest rate swaps.

All other financial entities will be required to clear swaps beginning on June 10, 2013, for swaps entered into on or after that date. Buy-side market participants transacting swaps must determine whether they are subject to the mandatory clearing requirement.

Although the new European Markets Infrastructure Regulation (Emir) has technically been in force since last summer, its regulatory requirements are only now beginning to take hold.

“The futurization of swaps has been very much of a U.S. story because of the Dodd-Frank Act,” said Stephen Cottrell, head of product development for fixed income at NYSE Liffe, the derivatives trading arm of NYSE Euronext.

NYSE Liffe’s € Swapnote is a bond future referenced to the swap market. “It is exchange-traded and centrally cleared, and can be viewed as a bond futures contract that is priced in line with the swaps curve,” said Cottrell.

Average daily volume for € Swapnote was 3,576 in January 2013, up 21% from 2,831 in January 2012.

“We’ve got a successful and actively traded contract, even though the clearing mandate hasn’t yet kicked in, so that gives us confidence in this contract’s potential,” Cottrell said.

Cumulative volume on CME Group’s deliverable interest rate swap futures contracts is 242,000 since they began trading on December 3, 2012.

The contract, which were created to meet demand from financial market participants including banks, hedge funds, asset managers and insurers, have the same economic exposure as an interest rate swap, the margin and liquidity benefits of a futures contract, and at expiration all open positions deliver into a CME Cleared Interest Rate Swap.

NYSE Liffe’s Swapnote contracts are denominated in Euros and U.S. dollars. In each currency, there are Swapnote contracts on bonds with two, five, and ten-year maturities.

For example, the Ten-Year € Swapnote contract is a future on a bond with ten years to maturity (at the contract’s value date). This bond pays an annual coupon of 6%, and repays the capital at maturity.

In reality, though, this bond does not exist – it is a ‘notional bond’. Rather than require delivery of a bond chosen from a specified list, the Swapnote contract is cash settled against a value calculated by NYSE Liffe.

“They are futures contracts that give dealers a way to hedge their swap book risk more accurately,” Cottrell said. “Because they are futures contracts, they enable people beyond the limited crowd of swap dealers and large institutors to interact with the market and get access to the swap curve.”

Although the product has been in existence for ten years, the regulatory changes that are taking place have given it renewed impetus.

“In the US and Europe, the regulatory environment is pushing for more clearing and transparency, and more electronic trading within the swaps space,” Cottrell said. “Here is a futures contract that replicates the economics of the swap curve and is centrally cleared, so it ticks all the boxes.”

Standardization of derivative contracts across trading venues “means that there will be a move away from the quote driven market on which OTC derivatives currently trade, which is associated with high counterparty risk exposure,” said Ramandeep Lakhan, associate consultant at Capco, in a blog. “MiFID II will build on Emir and enforce mandatory electronic trading of OTC derivatives exclusively on regulated markets, MTFs, OTFs and permissible third country trading venues.”

NYSE Liffe has worked with the sell side to provide liquidity for Swapnote, while the buy side has provided the demand.

“On the liquidity provisioning side, we’ve got an internal swap desk that’s market-making the contract, as well a large independent market maker, and we are speaking to banks about playing a role as market makers,” Cottrell said. “On the buy side, asset managers and other hedgers are accepting the idea of a swap future because the swaps market needs greater transparency. Our task now is to grow that participation.”

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