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Trending Now: The "Futurization" of Swaps
Practical Law Legal Update 4-524-3077 (Approx. 4 pages)
Trending Now: The "Futurization" of Swaps
by PLC Finance
| Published on 21 Feb 2013 • USA (National/Federal) |
The CFTC held a recent roundtable on the migration of market participants away from swaps and toward futures in order to hedge risk while avoiding burdensome regulations and regulatory uncertainty in the swaps market.
Recent buzz in the derivatives markets has focused on the so-called "futurization of swaps." On January 31, 2013, the CFTC held a roundtable on the topic, and the following weeks have featured much discussion on market migration from swap transactions to futures contracts because of burdensome Dodd-Frank over the counter (OTC) swaps regulation.
Swaps traders have recently begun to examine futures as an alternative to swap transactions in order to avoid certain Dodd-Frank regulatory requirements, including but not limited to:
- Registration requirements for swap dealers (SDs) or major swap participants (MSPs).
- Central clearing for swap transactions, which requires the availability of funds for margin collateral and fees.
- Increased margin requirements for swaps, as compared to futures.
The futurization of swaps refers to the use of futures to mimic the risk allocation functions that OTC swaps currently play in the market. This is possible because swaps function as a string of individual futures contracts that are aggregated to hedge risk over a specific period of time and against a specific set of risks. By using a series of futures contracts, swap traders can hedge risks without subjecting themselves to regulations that are only applicable to swap transactions. Certain exchanges have begun to produce new exchange traded financial products that mimic the behavior of swaps in just such a way, including, among others:
- The Eris Exchange, which trades futures that replace the cash flows of a swap transaction. These futures can be based on the interbank curve, which offers a more accurate hedging device, similar to swaps, as opposed to futures based on the treasury rate.
- The CME, which trades futures that convert into cleared swaps on the contract's expiry date.
Despite the functional similarity between swaps and certain futures, the regulation of swaps and futures has diverged. While some at the roundtable expressed the view that Dodd-Frank swaps regulations are overburdensome, others argued that regulation of the futures markets is too lax and should be brought in line with Dodd-Frank swaps regulation. As a result, a major topic of discussion at the roundtable was the disparity in the playing fields between swaps and futures, including, among other things:
- Different margin requirements for swaps and futures. Swap margin requirements include a 5-day value-at-risk charge, while futures margin requirements only require a 1-day value-at-risk charge. The "value-at-risk charge" refers to the number of days of exposure that must be covered by variation margin collateral posting.
- Different block trade requirements. The CFTC has proposed setting relatively high minimum block requirements for swaps traded on a swap execution facility (SEF). A SEF is a smaller electronic swap trading platform offered by a broker or dealer. On the other hand, each designated contract market (DCM) can set its own minimum trading block requirements for futures contracts, which results in minimum block requirements that are inconsistent, but generally much smaller than those proposed by the CFTC for swaps.
- Divergent regulatory framework. Swaps and futures may require divergent regulatory regimes because of differing availability and underlying attributes of swaps and futures. For instance, swaps may trade through any SEF or DCM, while futures may only trade on the DCM on which they are listed.
A migration from swaps contracts to futures contracts could have a positive impact on market participants because:
- The use of futures allows market participants to decrease the nominal volume of their swaps, potentially allowing them to avoid registration as SDs or MSPs with the CFTC (see, Practice Note, Is Your Client a Swap Dealer or Major Swap Participant? Breakdown of Final Dodd-Frank Definitional Rulemaking).
- Transaction costs associated with futures could be lower. For instance, margin collateral requirements for cleared swaps are based on a five-day value-at-risk charge, while margin requirements for futures are based on a one-day value-at-risk charge. So futures could tie up less collateral in margin accounts. However, since the number of standardized futures contracts required to hedge a unique position is generally greater than the number of swaps contracts required (this is true in all cases except for swaps where there is just one payment exchange), the operational costs of utilizing futures could be higher.
- Futures exchanges are already established and fully functioning, resulting in reduced regulatory uncertainty surrounding futures, which are cleared and exchange traded.
- Certain exchanges that are already set up for futures and options trading will become swaps clearinghouses (referred to as central counterparties or CCPs), which will allow these CCPs to clear a wider variety of products. This will facilitate movement of positions between swaps, futures and swap futures.
- Many more SEFs are registering, which will reduce the current emphasis on bilateral trading arrangements, which is the manner in which swaps have traditionally been entered into, using bilateral agreements such as the ISDA Master Agreement. This appears likely to usher in an era of increased standardization of swaps, which may begin to bear greater similarity to existing futures, rendering many standardized swaps unnecessary.
A migration from swaps contracts to futures contracts could have a negative impact on market participants because:
- Bilateral bespoke swaps allow parties to more precisely hedge risk exposure that is specific to their business. Hedging risk utilizing futures requires multiple financial instruments to hedge the same risk that a single highly negotiated and customer-specific swap can hedge.
- Even if multiple futures or futures specifically designed to act as swaps are used to hedge risk, the actual risk hedged through futures contracts may be slightly different from the risk to which the hedging entity is exposed. This risk is called basis risk, and generally exists to a smaller degree with swap transactions because they are individually negotiated to cover the specific risk of the hedging entity.
- Entities that use hedge accounting rules may fail those rules because of increased basis risk where futures are used.
While exchange traded futures may take the place of some of the less complex swap transactions used to cover relatively straightforward exposure, more complex swap transactions may not be so easily replaced. The benefit of less burdensome registration and margin requirements for futures contracts may be outweighed by the benefit of highly individualized, customized swap transactions.
End users that utilize swaps to hedge commercial risk that arise in their everyday business are generally exempt from the clearing requirements of the Dodd-Frank Act (under the commercial end-user exemption). These entities are permitted to use customized, bespoke swaps to hedge risk specific to their business without being required to tie up excessive amounts of capital as margin collateral for the transaction or for other costly clearing requirements. While this may provide some relief to end users, if most other market participants migrate to futures to replace swaps, increased transaction costs and reduced liquidity could reduce the benefits to end users of the exemption. For more information on the Dodd-Frank commercial end-user exemption, see The Commercial End-user Exception to the Dodd-Frank Mandatory Swap Clearing Requirement.