Standardised OTC swaps spice up futurisation fight

Last month saw the launch of a template for a new standardised interest rate swap product – an attempt to protect swap market liquidity from the threat of futurisation. The first product based on the template could be launched within weeks, but even some dealers are sceptical. Peter Madigan reports

In the contest between over-the-counter interest rate swaps and exchange-traded swap futures, the listed product has two great advantages – it requires less margin to clear, and its standardised terms make the risk fungible. No matter how many times a user trades the same future, it only has a single position on its books, with each transaction adding to, or subtracting from, the risk.

OTC swaps, by contrast, boast liquidity, and some market participants are hoping to keep it that way by aping the standardised terms of the swap future. An initiative started by a group of buy-side firms in mid-2012, has now produced an industry template for what’s known as the market-agreed coupon (Mac) interest rate swap, which was unveiled at the annual meeting of the International Swaps and Derivatives Association in Singapore on April 24, a week after Risk revealed that a product based on the contract is expected to start trading on fledgling derivatives exchange trueEX by early June (see box).

Put simply, the Mac swap aims to neutralise one of the twin advantages of the swap future, says a senior trader at one of the buy-side firms involved in the project. “Swap standardisation is a defensive act to protect the swaps business from being converted to futures. It reduces the need for that conversion because swap users will now have the standardisation benefits of futures in the swaps market,” he says.

The template would allow a family of identical products to trade on a variety of platforms, with standardised coupons and maturities that would start and end at quarterly international money market (IMM) dates, as in the futures market. A user executing two of these trades at an interval of one day would get the same fixed coupon and the same maturity date, allowing the trades to be netted off – or added together – perfectly. Some banks already allow their biggest clients to trade this way today, but making IMM swaps available more broadly would be a radical departure from typical practice in OTC markets where, for the overwhelming majority of market participants, two 10-year swaps traded a day apart would have two different rates and generate two separate line items.

But some dealers see a flip-side to this argument, fearing a standardised swap product further blurs the boundaries between the futures and OTC markets, potentially making it easier for liquidity to migrate into listed derivatives (Risk October 2012, pages 34-38).

Swap standardisation is a defensive act to protect the swaps business from being converted to futures

“It’s quite speculative to try to figure how this will turn out, but on the one hand a more standardised product is presented as more homogeneous, which is good for OTC markets, while on the other, you could argue the more a product is standardised, the less differentiated it is from futures and ultimately could lose out to straight futures activity,” says one New York-based rates trader. “I think there is a fear that this standardisation process creates a much easier path towards futurisation. You could argue this is one step closer towards promoting the success of swap future contracts.”

Despite these misgivings, it only took two months for dealers to rubber-stamp the prototype contract handed to it by the buy-side, but that may have something to do with the clout of the firms backing the initiative. US fixed-income giant Pimco is understood to have been the driving force.

“A large west-coast money management firm was very active in starting this process and it reached out to a combination of buy-side and sell-side firms,” says one of the asset managers participating in the discussions. BlackRock was also involved – the two firms are big, and vocal, users of OTC derivatives.

The view from other asset managers on the Securities Industry and Financial Markets Association (Sifma) group was also positive – the belief is that a standardised contract will help preserve swap market liquidity, says Matt Nevins, associate general counsel to Sifma’s asset management group.

“The issue of how the Mac contract relates to the futurisation trend was discussed within the working group, and we concluded these contracts will help the swap market structure. There are benefits to be gained from them that don’t currently exist in the futures world. The available tenors for Mac swaps may grow over time to include different points along the curve. These contracts would also not just be US dollar interest rate swaps but would include euros, sterling, yen, Canadian and Australian dollars, so there will be a wider range of instruments than you will see with deliverable interest rate futures,” says Nevins.

The Mac swap template offers standard coupons for nine different contract tenors – at years one, two, three, five, seven, 10, 15, 20 and 30 on the yield curve – and is tradable in the six currencies Nevins lists.

The IMM dates will be the third Wednesday in March, June, September and December, with coupons set by referring to either the three- or six-month at-the-money forward-starting rate for the tenor and benchmark interest rate in question. The standard coupon for the next roll of the Mac contract would be reset every three months on each subsequent IMM date.

The market will be supported by an as-yet-unnamed joint Isda-Sifma committee of dealers and buy-side firms that will meet on a monthly basis to announce the standard coupon, start date and roll date of upcoming Mac contracts. This committee will not include trading venues, such as Dodd-Frank’s swap execution facilities (Sefs), or clearing houses as direct members, although these entities will be able to obtain observer status. It is anticipated that the inaugural meeting of the committee will be in the first half of May, leading to an announcement of the first standard coupons.

But the derivatives market is a complicated place, and its participants are driven by a variety of motives. For a corporate that wants to hedge an idiosyncratic debt issue, and achieve hedge accounting when doing so, a Mac swap will be too blunt. In contrast, an entity that is sensitive to margin requirements, may decide the new swaps are too expensive. The obvious danger is that it falls between two stools, as one senior London-based rates trader who was not involved in the project points out.

“There may be a place for this in the pantheon of fixed-income products, but to me it’s just an attempt to replicate a future. I don’t see why people are trying to do that when they could just trade the future,” he says.

So, will it take off? Sifma’s Nevins thinks so, but says it will appeal primarily to large-scale users of OTC swaps that are not motivated by margin requirements and simply want a more streamlined portfolio that is easier to manage. In other words, asset managers.

“There are participants that trade on this IMM-starting basis today, but the idea is to put some structure around it, creating additional liquidity. Portfolio compression is another huge element of this project. When the dates, coupons and conventions are all different, compression is much trickier, and it’s naturally simpler if you have trades with the same terms that are just facing in opposite directions,” says Nevins.

Another of the asset managers behind the initiative argues the Mac swap template is necessary to recognise the new realities of the swap market, in which liquidity could be dispersed across a multitude of Sefs and exchanges, each of which could otherwise launch its own version of the product (Risk April 2013, pages 38-41).

“These standardised products help solve some of the fragmentation of liquidity that is going to be created by Sef and exchange execution, by creating liquid points on the curve that we can trade on. As Sefs come online, if we didn’t come out with at least a minimum standard of contracts that the entire market would like to trade, one concern is that every Sef will come up with its own contract. In that instance I would have to go back to the same Sef I transacted on to unwind it, but with truly standardised contract terms I can transact at any platform I please – both on the way into a trade and on the way out,” he says.

Despite these benefits, some dealers are not sold on the idea. One criticism is that forward-starting swaps, trading on IMM dates, already have bid-offer spreads that are comparable with spreads on more traditional interest rate swaps. As such, sceptics say asset managers don’t need a new product to achieve more efficient portfolio compression.

“On my screen today I am showing the same price for a 10-year spot-starting swap and a 10-year IMM swap in the same size, so there is precisely the same liquidity in the IMM swap as in the straight 10-year. Having Isda agree standard coupon terms doesn’t change that fact and clients will be able to transact in the 10-year IMM swap at the same price regardless of whether this effort happens or not,” says one London-based rates trader.

That ignores the compression argument, though – if a large group of users starts trading the same standardised product, it could enable large-scale compression cycles, such as those run by Stockholm-based infrastructure firm TriOptima, to be extended into the dealer-to-client market. So far, compression services have covered interdealer trades only, but buy-side advocates of the Mac swap argue the new product will allow the same tear-up processes to be applied elsewhere, releasing margin as a result.

Dealers accept this, but question whether the potential benefit is worth the effort. “If you have a standardised contract, it is much easier to compress trades, and if you look at the success rate of TriOptima and other services to date, the compression percentages are actually very high relative to notional outstanding interest rate swap volumes published by the Bank for International Settlements,” says the New York rates trader.

“So the question is whether the marginal benefit achieved by standardising the contract is sufficient to push for it across the entire buy- and sell-side communities. With all the challenges facing the rates market today – from mandatory clearing and Sef trading to swap futures – is this effort sufficiently important to push for right now? I don’t think the entire buy-side community is convinced, so I suspect it will be a small subset of participants that sign up to these standard coupon products,” he adds.

Other dealers are more positive about the product. One New York-based swap trader cautions that it is impossible to treat the buy-side as a single entity, with a single set of needs, but adds that Mac swaps will appeal to some of the market’s most active participants. As a defensive strategy, in other words, it should work.

“Given all the differing trading objectives, it’s not possible to make assumptions about the entire buy-side interest rate market, but if you’re trying to capture the bulk of the flow you want to approach the clients that represent the biggest ticket source – the asset managers – and calibrate your platform to accommodate the way they prefer to trade. And that means standard coupons and standard maturities,” he says.

For now, whether standardised contracts emerge as a great success or simply a short-lived addition to the interest rate trader’s toolkit, dealers insist they will not be trying to undermine the product.

“Sell-side folks are involved in these discussions, and there is a recognition that there is a place for a standardised rates product. It’s not the case that dealers are trying to maintain bid-offer spreads by keeping the product non-standardised, it’s already quite a standardised product. What is happening here is that clients are arguing they need swaps to hedge duration risk and they want standard start dates, end dates and coupons,” says Paul Hamill, head of matched principal trading at UBS in New York.

 

BOX: SCSM swaps – the first Mac product?

Within weeks, fixed-income market participants will be able to trade the first product to be based on the market-agreed coupon (Mac) template. Sort of.

New York-based exchange trueEX plans to list the product – which it calls a standard-coupon, standard-maturity (SCSM) interest rate swap – in time for the second phase of mandatory clearing in the US on June 10, but it drew up its plans for the product, and began testing, before the Mac template was finalised by the industry working groups at the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association.

“The valuable work that the working groups have done on standardising coupons and maturities can manifest itself on listing contracts on a regulated exchange. TrueEX is actually listing these consistent products – what we are doing is standardising the coupon and the maturity, along with the roll dates and other details that are important to buy-side participants,” says Sunil Hirani, the exchange’s chief executive.

“We are testing with market participants and expect to go live sometime around the introduction of the second phase of the clearing mandate on June 10. As you get more and more participants using clearing houses, there will be an emerging pain point to manage these positions. Having a set of contracts with a standard coupon and standard maturity is an efficient way to manage these books,” he adds.

The SCSM swap will list in eight tenors ranging from one to 30 years, with start and end dates in March, June, September and December. The initial benchmark rate for the product will be three-month Libor with the coupon resetting on the at-the-money forward rate for the tenor in question, and the new coupon being announced the day before the contract is listed for trading. It will be available to clear at CME Clearing and LCH.Clearnet’s SwapClear, Hirani says.

Standardisation is designed to help large-scale derivatives users manage their books more efficiently by making the product fungible, as is the case with futures and swap futures. But while those rival products benefit from a requirement that clearing houses assume it will take at least a day to close out positions, over-the-counter swaps will attract a minimum of five days’ worth of margin.

One of the buy-side firms involved in the initiative says margin will not be a big part of its decision-making process when choosing what products to use, so swap futures and standardised OTC swaps can be compared on their other merits. “The difference between two-day margin and five-day margin to a firm like ours, which is real money and unleveraged, really does not matter that much, though for a leveraged hedge fund, that margin differential would be a bigger concern,” says Michael O’Brien, head of global trading at Eaton Vance in Boston.

Hirani of trueEX concedes margin is an issue for some buy-side firms, but says it is just one among many considerations. “Two-day margin versus five-day margin is just one of 10 factors that a buy-side participant considers when choosing to trade through a swap or a future. Liquidity, time for liquidation, systems, human resources, tax, accounting, maintenance costs, along with roll costs and fungibility are the complexity of factors the buy side is looking at – not just two-day versus five-day holding periods,” he argues.