Eris Exchange: Brady's bunch aims to make swap futures a hit

Swap futures have had some bad press in recent weeks, but Eris Exchange insists it can make them work - and add diversity to the OTC market as a result

An unstated aim of the Dodd-Frank Act is to open up the over-the-counter derivatives market to new entrants, loosening the stranglehold enjoyed by the big dealers and dealer-backed clearing and trading venues. Various names have thrown their hats into the ring but with little obvious success: the would-be interlopers claim that’s because they’re battling entrenched, vested interests; dealers claim it’s because business models borrowed from the listed derivatives world do not work in the OTC market (Risk October 2011, pages 16–20).

Chicago-based Eris Exchange – named after the Greek goddess of discord – aims to buck that trend. And chief executive Neal Brady says it isn’t relying on Dodd-Frank, or its transatlantic counterpart, European Market Infrastructure Regulation (Emir), to do so. “Emir or Dodd-Frank aside, I think there is a strong market demand to do two things: to trade and clear with a central counterparty and have access to additional counterparties. So we allow that to happen,” he says.

Initially, the additional counterparties Brady has in mind are Eris’ founders – and existing market-makers on the platform – Chicago Trading Company, DRW Trading, Getco, Infinium Capital Management and Nico Trading. The Chicago-based firms are often labelled high-frequency or algo shops, but prefer to be seen as liquidity providers – their hope is to play the same role in OTC markets. That will depend in part on acceptance of the Eris product.

Unlike most other post-Dodd-Frank platforms, which take existing OTC products and allow them to be traded electronically, Eris is offering a futures contract that aims to replicate OTC interest rate swaps. In other words, it’s hoping to draw away some portion of OTC volume with a product that consumes less margin. One other new entrant that tried to do the same – the Nasdaq OMX-backed International Derivatives Clearing Group (IDCG) – is the defendant in a lawsuit filed on September 16 by Jefferies, an investment bank. Jefferies alleges it lost tens of millions of dollars after accepting IDCG’s claims that its interest rate swap futures would economically mirror the OTC swaps from which they were converted (see pages 38–42). IDCG has stated its intent to defend all claims.

Brady admits clients have asked whether similar problems could emerge with Eris’ own swap futures contract, but he insists the Eris contract is “very different” from IDCG’s. Chiefly, that’s because the latter failed to effectively capture the economic effect of collateral posting in an OTC trade, he says – but Eris also uses a swap curve provided by its clearer, CME Group, for clearing and settling its futures contracts, he adds.

“Our contract includes the all-in cost of synthetically replicating the posting of collateral and the interest passed back, which can accumulate to a fairly large number, depending on the tenor of the swap. We also clear and settle to the CME swap curve, so the inputs to settle the curve are determined by the CME using a broad range of inputs and factors.”

If questions have been asked about the Eris product, there’s far less uncertainty about the company’s model – while other trading venues seeking to capitalise on Dodd-Frank are still waiting to register as a swap execution facility (Sef) under rules that have yet to be finalised, Eris has chosen a more traditional route. It is a futures exchange, regulated by the Commodity Futures Trading Commission (CFTC) – and was added to the list of 17 currently operating designated contract markets (DCMs) on October 31.

“Whereas the Sef framework is still being debated on an indeterminate timeline, the DCM is a very well-known, trusted framework,” says Brady. “By being a DCM and trading a futures contract, all the issues around capital efficiency, how to margin and who has access to the product are already clear and they’re favourable to us.”

So, how much traction does Eris have so far? Brady insists there has been strong interest in Eris from both the buy and sell side. He declines to give further details, but it’s not just hot air. A senior figure at one large asset manager picks out Eris from the crop of post-Dodd-Frank trading venues as one that is making waves: “I think Eris is coming up with interesting enough contracts that they have definitely got the attention of the buy side,” the executive says.