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November 1, 2012 5:32 pm
Some four years after the demise of Lehman Brothers and near-failure of AIG illustrated the systemic risk of over-the-counter derivatives and prompted a regulatory backlash, the vast US swaps industry faces being cut down to size.
The explosive growth of US swaps in recent decades was built on offering investors a customised risk management product that contrasted with the much smaller and more rigid listed futures alternative.
But at this week’s annual Futures Industry Association gathering in Chicago, the so-called “futurisation of swaps” figured prominently during panel discussions.
“It’s the headline topic here in Chicago,” says Donald Wilson, chief executive at DRW Trading Group, who moderated an FIA panel discussion on Wednesday.
“What we are talking about here is putting OTC products on an exchange,” says William Rhode, director of fixed-income research at Tabb Group.
This follows a series of moves recently by big futures exchanges seeking to take a bite out of the OTC swaps business.
This rising challenge comes in spite of aggressive lobbying by the swaps industry to forestall OTC swaps from trading like futures – where trade sizes are smaller and transactions more frequent.
Swaps can extend for periods well beyond a futures contract that has fixed maturity dates.
The greater flexibility of OTC swaps and the much larger notional size of their trades explains why they dwarf the market for listed futures. But the greater size of the OTC swaps market reinforces the links between investors and can feed financial contagion in times of crisis.
With the credit risk of OTC swaps between customers and banks being pushed into central clearing houses, the transaction of such trades is also migrating towards the futures market.
In the pending new world of regulated OTC swaps, a much higher cost of capital mitigates against their extensive use but futures loom as being cheaper.
That shift is already under way in energy markets where traders from oil companies to hedge funds insure against or bet on moves in petroleum, gas and electricity.
Last month, IntercontintentalExchange (ICE) converted its cleared energy swaps to futures, partly to help companies such as commodities trading houses to avoid the cost of designation as swap dealers.
CME Group, the largest US derivatives exchange, started allowing more OTC swaps to be executed as so-called “block” futures trades, which “will not be subject to swaps regulation”, it said in a notice.
“Because we already had a central limit order book and a clearing house, it was not a particularly big stretch for the industry to go to futures,” says Jeff Sprecher, ICE chief executive.
The expected lower cost of trading is a key factor behind the push for futures at the relative expense of OTC swaps. This push is gaining momentum as the US Commodity Futures Trading Commission has not yet finalised rules for how swaps will trade on swap execution facilities (Sefs), new non-exchange trading platforms proposed under the Dodd-Frank Act.
A big concern for the swaps industry is that final Sef rules may be too strict and impose higher costs on users of OTC products, only encouraging greater use of futures.
“The whole swap to futures evolution is expected and an appropriate response to regulation and probably consistent with what the CFTC wanted,” says Mr Rhode.
Widespread adoption of futures calls into question the fate of Sefs. Swaps traded on these platforms were supposed to be cleared anywhere but futures keep intact the vertical integration of execution and clearing – potentially consolidating exchanges’ power.
“It may be that, by the time the CFTC finalises swap rules, no one will be trading energy swaps any more,” says Michael Cosgrove, a veteran energy brokerage executive.
In the much larger world of interest rates, CME is set to start trading a swap futures contract this month with the help of banks such as Goldman Sachs, Credit Suisse, Citigroup and Morgan Stanley. ICE next year plans to introduce a new credit derivatives future based on the liquid and popular indices.
What is clear is that a futures-style solution now dawns for the three big derivative swap markets in energy, interest rates and credit.
This migration raises the prospect that once interest rates or energy prices change rapidly, many investors may be caught out by relying on a future rather than a customised swap that better matches their portfolio’s risk. “The CFTC has prescribed a futures model for the swaps market and we are starting to see it,” says Mr Rhode.
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