A little-noticed recent step by a US broker could be a giant leap towards a swaps-for-all utopia dreamt up by a pair of Nobel Prize winners two decades ago.
That is the hope harboured by Interactive Brokers and Eris Exchange, whose futures replicating the cashflows of interest rate swaps became tradable via the electronic broker in January. Now all of the broker’s clients, including individual investors, have access to a swaps market that was previously the preserve of large financial institutions and big corporations.
In theory, US homeowners can use the bourse’s swap futures – the most liquid available – to manage mortgage interest rate risk without the expense of refinancing their loans; Mom & Pop shops can hedge out interest rate risk in bond portfolios with a single contract and a single commission to match; and retail investors of all stripes can trade the futures to speculate on interest rates as volatility returns.
“The majority of people in the US either have a mortgage or a loan. They understand that they’re exposed to rates, but very few have access to an instrument to manage this risk,” says Geoff Sharp, the head of sales and marketing at Eris Exchange, which pioneered swap futures in 2010 and has been trying to build liquidity ever since.
Andrew Wilkinson, chief market analyst at Interactive Brokers and a former bank rates trader, agrees, adding: “The ability to make a transaction that previously I could only make on a bank desk and for practically no commission is a real opportunity.”
Whether non-professionals will grab the opportunity is another question. Some argue broad take-up of swaps by retail investors faces practical hurdles, including a lack of savings and trading expertise, while others say it is not even desirable.
Darrell Duffie, professor of finance at Stanford University’s Graduate School of Business, is one prominent sceptic.
“Swap markets should be more democratic, but I’m worried about opening them up to retail-level investors without a significant filter on protecting those investors from getting into risky positions that they might not properly understand or be able to handle,” he tells Risk.net.
The idea of opening up swaps markets to individuals goes back to a pre-crisis vision by two high-profile economists.
In the 1990s Robert Merton, professor of finance at the Massachusetts Institute of Technology’s School of Management, advocated a type of derivatives contracts that could be tailored to the needs of each retail investor. In a 1998 paper, he proposed what he later called “life options” – derivatives-based instruments allowing investors to hedge everyday risks and expenses including illness, higher education, marriage, divorce and retirement.
And in a 2003 book, The New Financial Order, Robert Shiller, professor of economics at Yale University, envisaged a vast expansion of derivatives markets, which would enable ordinary people to act directly to hedge against everyday financial risks.
DIY mortgage hedging
A clear sign this new world is finally emerging could come from one potential use of swap futures touted by Eris Exchange: the hedging of mortgages by homebuyers.
The bourse’s Sharp says doing so could offer sizeable cost savings. As an example, he says a homeowner could hedge the interest rate risk on a $100,000 mortgage balance for the lifetime of the loan with an upfront outlay of only $2,500, which is a ballpark figure for the initial margin required. There would be no other expenses as Interactive Brokers does not issue daily margin calls; instead, it uses a real-time risk monitoring system and automatically shuts down positions approaching losses that cannot be covered by initial margin.
Refinancing a US mortgage of the same size – to take advantage of lower interest rates, for example – can cost at least as much in loan origination, legal and other fees, but the expense arises every time a homeowner replaces an existing mortgage with a new one, and the process usually takes three months.
Most US mortgages are fixed-rate and are refinanced regularly. Freddie Mac data shows the median age of refinanced mortgages was 6.9 years last year, suggesting that a typical 30-year loan is refinanced roughly four times in its life. According to a 2017 survey from the Federal Reserve Bank of New York, the mean outstanding balance for a US mortgage is $137,187.
Interest rate swap futures allow retail investors to enter into the equivalent of an over-the-counter swap. Getting the same exposure by doing the swap directly with the bank would be “impossible”, in Wilkinson’s words. That is because the associated costs, such as due diligence checks, would be too high and the trade too small for a bank to bother with. According to the SwapsInfo service from the International Swaps and Derivatives Association, the average trade in interest rate derivatives, of which swaps are the most common type, amounted to $157.8 million in 2017 – far above what any retail investor would get involved with.
Although homeowners may find it cheaper to hedge their mortgages via Interactive Brokers than refinance through a bank, they will have to contend with the risk of their hedges being liquidated. The broker notes in its rules that liquidations may occur in unfavourable and illiquid market conditions. In that case, the mortgage would either become unhedged or the homeowner would need to put up more capital to create a new hedge.
Blue-sky thinking or pie in the sky?
Sharp acknowledges homebuyers are unlikely to flock to swap futures just yet, but predicts an eventual change in mindset: “I’m not saying those are the people that immediately trade swap futures, but a conceptual development is taking place.”
If and when US retail investors start hedging their mortgages in earnest, the impact such a radical shift will have on the interest rate swaps market is hard to predict. Some believe the yield curve could steepen with higher demand for 30-year swaps. In contrast, current mortgage hedging – done by banks in wholesale markets – is spread across the curve.
But one rates trading expert believes any steepening could soon be tempered as homeowners might choose to lock in rates for shorter periods or not to hedge at all if that became too costly. He adds the market could also adapt by creating new products.
The two firms’ long-term hopes for swap futures are not limited to mortgage hedging. At some point, Interactive Brokers may offer Eris futures on US credit default swap (CDS) indexes, both investment-grade and high-yield, although it has no current plans to do so. The platform’s Wilkinson says that, as a hybrid between equities and bonds, CDS would enable retail traders to hedge corporate exposures in their stock and bond portfolios or speculate on the financial health of individual firms.
Sharp expresses a broader vision still, saying the opening up of Eris interest rate swap futures could be the start of a revolution in access to derivatives. He draws parallels with the UK’s “Big Bang” deregulation of the 1980s, which made equity trading much simpler and cheaper, enabling retail investors to enter the market en masse for the first time.
“Everyone could suddenly fill out a form and get a piece of British Gas,” he says.
How can a retail investor be efficient at hedging their mortgage? That’s what the bank doesUS-based rates market structure specialist
For sceptics though, such radically democratised derivatives markets are little more than a pipe dream.
Some question whether individual investors will be able to find the right small trades at a good price in a market that is geared towards large deals by big banks.
“How can a retail investor be efficient at hedging their mortgage? That’s what the bank does,” says a US-based rates market structure specialist. “I could go and hedge my jet fuel exposure because of all the travel I do, but the airline has economies of scale. All these people would effectively become hedging managers and that’s something that even professionals struggle [to do].”
He adds that the vast majority of potential retail investors in the US are simply not rich enough to put any money on the line.
“Two-thirds of Americans have less than $1,000 of savings. I don’t see how you jump from that to having that retail class of investors use credit or fixed-income derivatives to manage their life events.”
And while Duffie acknowledges swaps’ ability to save consumers money, he worries about the dangers to retail investors inherent in taking “potentially extremely high-risk positions with relatively little capital”.
He adds it is unlikely that individuals will take up interest rate swap futures in large numbers, noting that even much better-established interest rate products such as Eurodollar and Treasury futures are traded only by a small number of sophisticated and wealthy retail investors.
In fact, it is this type of experienced small investors – who used to trade for banks or still do, and invest their own money – that Interactive Brokers and Eris Exchange are targeting in the first instance.
In reality, the brokerage’s rules mean its retail clients are mostly wealthy individuals, says Wilkinson. The minimum deposit for opening an individual account is $10,000 in cash or stock equivalent, whereas most other US brokers require only $500 and some do not have a minimum requirement at all. The brokerage’s average client carries out more than 400 trades per year compared with Wilkinson’s estimate of under 10 per client for the majority of US retail brokers.
“Those are the kinds of people who would use [interest rate swap futures]: people who’ve used those products in the past and those who have a bias towards understanding what central banks say and become self-educated on a product in which you’re either paying or receiving fixed rate in exchange for a variable Libor-based rate,” he says.
Switch and save
Wilkinson argues it would make sense for such investors to switch to interest rate swap futures from currently popular interest rate hedging and speculation strategies.
One common way to bet on changes in the shape of the interest rate curve is via calendar spreads. These trades involve buying contracts such as Eurodollar or short sterling futures in one calendar month and selling a similar contract in another calendar month to take advantage of any change in the price differential between the two.
For investors more used to trading the curve in OTC markets, interest rate futures have limitations. Futures prices have a linear relationship with underlying rates, whereas interest rate swaps are more sensitive to rates moves, with profits and losses increasing disproportionately to any upward or downward move in rates. Eris swap futures mirror that so-called convexity of the OTC instrument.
Meanwhile, for investors looking to take on longer-dated interest rate exposure for hedging purposes, short-term interest rate futures can prove costly, Wilkinson says. The quarterly-expiring contracts are typically bought as a bundle of successive maturities to create a synthetic term investment replicating exposures available in the OTC swaps market.
“If you’re trying to hedge with Eurodollar futures, you’re going to have to use a strip or a bundle so you pay multiple commissions. The swap future is a single commission,” he says.
John Colman, director of the fixed income group at R.J. O’Brien, a non-bank futures commission merchant, says the newly available swap futures will probably appeal only to the most sophisticated individual investors.
“Just on a spread basis, if you can’t handle the volatility of buying a 30-year Treasury, you might be able to handle trading a 30-year Treasury against a 30-year Eris, so I could see it evolving that way,” he says.
Still, Eris Exchange is banking on eventual broad participation by retail investors. It currently offers only two- and five-year swap futures via Interactive Brokers but is trying to drum up interest for longer tenors all the way to 30 years, which would pave the way for retail mortgage hedging. As part of those efforts, the bourse sends Interactive Brokers clients a rates market snapshot every fortnight.
The exchange may have little choice but to rely on the man in the street. Its interest rate swap futures have failed to take off among large dealers as a viable alternative to OTC interest rate swaps in the interdealer market. Large bank clearing members have also been slow in offering the product to their institutional clients.
Trading volume in the futures amounted to $3.7 billion notional in February – tiny compared with the $2.7 trillion traded in OTC US dollar interest rate swaps in the same month, according to SwapsInfo.
So close, yet so far
Before the swaps-for-all utopia can become a reality, the markets need to be unlocked for another class of investors as well. Although institutional investors, such as hedge funds and insurers, are able to trade OTC swaps, they don’t always get the best deal.
For one, dealers still sit at least on one side of most swaps trades, despite the rise of US swap execution facilities (Sefs) since 2014. The Sef rules require certain swaps to be executed on a Sef, either via request-for-quote sent to a minimum of three people or on an all-to-all central limit order book (Clob).
Clobs have the potential to bring all market participants together in the same liquidity pool, but have struggled to gain traction for a variety of reasons. The request-for-quote system dominates, perpetuating the long-standing practice of eventually trading with a bank that has the best price.
“It’s not a particularly democratic process and not as competitive and efficient in matching buyers and sellers as would be the case on an exchange that is accessible to non-dealer firms on both sides of the market,” says Darrell Duffie of Stanford University.
In his view, developing all-to-all trading on exchange-like platforms is key to making swaps more accessible to institutional investors.
Secondly, institutional investors cannot always easily access the swaps they need. Unless they want to trade in their domestic currency or in one of the world’s top three currencies, many struggle to find the right counterparties and sufficient liquidity. Many local swaps markets, such as those in Mexican pesos and Scandinavian currencies, are dominated by regional banks, and only the largest buy-side firms have the requisite trading relationships with top banks in every region.
An aggregator platform such as the trueEx Sef may be part of the solution – the Sef offers 28 interest rate swap currencies, both cleared and uncleared, for round-the-clock trading. It hopes to attract enough institutional investors and dealers to move closer to the goal of wide-open swaps markets, says Sunil Hirani, trueEx chief executive and founder.
Editing by Olesya Dmitracova
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