Many people underestimate the threat that futures markets pose for the OTC swaps industry because they have been suckered into thinking of swaps as carefully custom tailored instruments. It’s true that a small fraction of the OTC swaps market cannot be replicated in the futures marketplace. And it is good that the Dodd-Frank Act preserved a space for customized swaps. But the vast majority of swaps are not custom tailored, or the custom tailoring is so inconsequential that it will be an easy matter for the futures market to serve the same purpose.
Even when the swap does contain some important element of customization, that is usually not the whole story. Many customized swaps can be broken up into 2 pieces: (i) a basic, plain vanilla swap, plus (ii) a small bit of customization that adapts the plain vanilla swap around the edges. The futures market can substitute for the plain vanilla swap, and then the OTC swap market can provide the customization around the edges.
It’s like buying a suit ready-to-wear, but having the tailor adjust the hems or waistline a little bit. So long as the adjustments are small, its an economic alternative to true customization.
An illustration of how a custom swap can be broken up into two pieces appears in an article by Sean Owen, Director of Fixed Income Research and Consulting at Woodbine Associates, published in a recent special issue of the Review of Futures Markets. He breaks up an irregularly amortizing 10-year interest rate swap into (i) a 7-year bullet interest rate swap, and (ii) a customized swap that produces the irregular amortization relative to the 7-year bullet. (H/T to CFTC Commissioner Scott O’Malia for highlighting the article)