Category Archives: packaging risk

Futurization #2 – why?

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.

Fear of the Future-ization of Swaps #1

The reform of the derivatives market, like other parts of financial reform, has been a very slow moving process. As when a giant ocean tanker is being slowly turned around, progress is so slow that it can be hard for the naked eye to confirm that the event is actually happening until the great ship’s silhouette overtakes a distinctive landmark on the horizon. And derivatives market reform, too, is happening. Each time the reform slowly approaches a new landmark on the horizon, the fact of reform is confirmed once again to proponents and opponents alike. And each time this happens, there are new howls from opponents that the ship’s current course will surely lead to disaster.

The current occasion for complaints goes under the heading “futurization of swaps.” Pre-reform, derivatives could either be traded in regulated marketplaces, generally called futures markets, or in the un-regulated marketplaces, generally called the OTC swaps market. The Dodd-Frank Act brought regulation to the OTC swaps market. Those regulations are only now beginning to take effect, or the deadlines are approaching. As that happens, companies on all sides of the derivatives markets are beginning to rethink where they should do their derivatives business. Should they continue to trade swaps, or can they get the same result using futures? Should they continue to market swaps, or should they now market futures? The swaps marketplace used to have the advantage of being unregulated, but as that advantage appears to be disappearing, where is the rationale for swaps? Derivative consumers and producers alike are giving the futures markets a fresh look. Some swap products have been relabeled and moved over to futures markets. Other, new futures products are being developed as substitutes for old swap products.

Obviously a major shift of business from the swaps market to futures markets threatens major business interests. Throughout the legislative battles leading up to Dodd-Frank, and the rulemaking and legislative battles surrounding implementation, the big banks that controlled and profited from the OTC swaps market hoped to preserve their monopoly. So far, they have mostly failed. The current debate about the ‘futurization of swaps’ is a major milestone in the process, and it is no surprise that it is raising new howls. These interests are complaining that the legislation is killing the swaps market, ruining a valuable financial innovation.

In the coming days, I will look at various arguments being made against the futurization of swaps. None of them hold up.

So that’s Delta hedging!

Lots of commentary on the web about the news that Delta Airlines is thinking about buying ConocoPhillips’ Trainer Refinery as a way to hedge the cost of jet fuel. Liam Denning at the WSJ’s Heard on the Street column offers a concise statement of the critical view.

Packaging Exposure to China

Risks usually come in a bundle. If you want exposure to a particular factor risk – or you want to hedge that particular risk and concentrate your exposure onto other factor risks – you may have to find a way to create that exposure synthetically. Investment managers are constantly looking for ways to do this. The Financial Times had a nice piece on getting exposure to China risk. Hedge fund manager Hugh Hendry seems to think that a portfolio of Japanese corporate bonds has a big China exposure.

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