Betting the Business

Why Futurize Swaps?

Futurization is the movement of derivative trades out of the OTC swaps marketplace and into the futures marketplace. There are different ways in which this shift may take place. Economically, they all have one thing in common: a recognition that there is in fact nothing special about swaps as a financial instrument. In general, any package of risk that can be structured via a swap can also be structured using futures and options contracts that can be traded in the futures marketplace.

The essential distinction between the OTC swaps marketplace and the futures marketplace is the regulatory rules, not the product designs that can be offered. Of course, a difference in regulatory rules can be economically significant, too. But it is important to keep straight the real source of any economic impact.

Prior to the Dodd-Frank Act, the OTC swaps marketplace lacked regulatory oversight, transparency and clearing, and the vast majority of derivative trades were executed in this marketplace as a result. After the Dodd-Frank Act, all OTC swaps trades are subject to regulatory oversight, and the vast majority must be traded transparently and cleared. There are exceptions that allow the OTC swaps market to continue offering swaps that are custom designed, and therefore ill-suited to exchange trading and clearing. However, for the vast majority of swaps, the Dodd-Frank Act removed the main advantage of the OTC swaps marketplace. With the mandates of oversight, transparency and clearing, the main raison d’être is gone.

Consequently, all players in the industry are now reassessing the choice of venue for derivatives trades: the OTC swaps market or the futures market. When the new calculus leads them out of swaps and into futures, that is the essence of the futurization of swaps.

How is the futurization of swaps to take place? I group the different ways into two main categories.

First, in many cases, plain vanilla futures and option contracts can easily substitute for swaps.

This is exemplified by the recent decision by the ICE to simply switch its cleared energy swaps into futures contracts. There was more to it than simply changing the package label, but not much more. ICE’s cleared energy swaps may be a special case for the ease with which such a transition can be executed, but from an economic standpoint it is much more representative than is yet widely recognized.

The vast majority of interest rate and foreign exchange swap transaction could be readily supplanted by plain vanilla futures and option contracts, as can other commodity swaps. For example, the CME’s IMM has long offered interest rate and currency futures which serve the same risk packaging function as interest rate and currency swaps. But these products were overshadowed by the OTC swaps marketplace because that marketplace had the advantage of not being regulated. Now that the Dodd-Frank Act has imposed comparable regulatory rules which remove the advantage of the OTC marketplace, these products may once again come out from under the shadow of the OTC and steal back the business. That hasn’t happened yet. But be patient.

A second, more contorted category involves attempts to somehow trade swaps, but to do it under the futures regulatory rules. These are the so-called “swap futures”. One example comes from the CME, which, in September, announced plans to launch its interest rate swap futures product. This is a futures contract where the underlying product is a traditional interest rate futures contract. So long as the customer owns the futures contract, the margining and other regulatory rules of the futures exchange apply. But, if the contract is held to delivery, then the customer finds itself holding an OTC swap, and the margining and regulatory rules of the OTC swaps marketplace then apply. Another example comes from the upstart Eris Exchange, which launched its interest rate swap futures product back in 2010. Instead of making the underlying product an actual swap, Eris cash settles its futures product to mimic those on an OTC swap.

This second category has all the buzz, currently. But perhaps not for long. The push for this second category is predicated on the idea that it is possible to have the best of both worlds—the current regulatory arbitrage benefits of the futures marketplace along with the economic advantages of swaps. But there never were any special economic advantages of swaps, so the underlying rationale for swap futures is faulty. After the buzz dies down, and the players recognize the problem, the action may turn back to the first category. On that, we are still waiting. Be patient.