Futures replacing OTC derivatives – will it work this time?


With the OTC derivatives reform’s clearing obligation finally coming closer in Europe and the USA, there is one topic that seems to dominate blogs, news, forums and social media – the question of whether interest rate swap futures will have the potential to replace interest rate swaps as the tool of choice for generic risk transfer.

In our constant engagements in helping clients to adapt their business model, business processes and system landscape to cope with new regulatory requirements, we typically also discuss alternatives to OTC derivatives, and discovered very different opinions from people that trade OTC derivatives.

The OTC market is huge, summing up to nearly USD 640 trillion of notional by mid 2012 – interest rate swaps accounting for over 77%. The market is huge because OTC derivatives historically had some unbeatable advantages. They are customizable to any extent, they do not involve any fees, there is no margining obligation, there is no disclosure obligation and the market is very liquid.
Also, trading OTC derivatives is very lucrative for banks, as the bid ask spreads allow for large margins.

Given those advantages it is no real surprise that attempts of exchanges to bring their new and innovative swap futures products to live have never resulted in a significant adoption in the market. CME’s first attempt, the interest rate swap future, has been around since more than 10 years and their newest addition, the deliverable swap future as launched in December 2012, has not yet gained traction as well – neither have the Eris swap futures launched in October 2011.

However, in the light of the OTC derivatives reform the advantages of OTC swaps are diminishing. Central clearing causes all kinds of fees together with a very intense margining obligation that make trading OTC derivatives more expensive.

Also regulators around the globe are implementing rules that call for electronic execution via SEFs in the USA or OTFs in Europe and demand full transparency, which will consequently lead to much more competition and therefore much lower bid ask spreads.

Hence, profitability of trading such OTC derivatives will shrink.

This could be the ground-breaking difference in comparison to 10 years ago, when the industry rejected the futurization of OTC derivatives. Because of that, traders or asset liability managers are seriously considering to evaluate swap futures as an alternative to OTC derivatives. So the game is now set to change and swap futures might indeed have their chance to attract a significant share of the swaps market.

Let’s have a quick look at the pros and cons as of today:

Pro OTC interest rate swaps (IRS):

  • Unrivalled flexibility in terms & conditions with a vitually unlimited number of possible variations
  • Very liquid market

Contra OTC interest rate swaps (IRS):

  • High fees and margining costs for centrally cleared deals
  • High capital ratios for non-cleared deals
  • Very limited margin efficiency across other products and counterparties
  • Regulatory uncertainty

Pro swap futures:

  • Low cost
  • Reuse of existing technology and processes
  • Regulatory certainty
  • Margin efficiency across products
  • Lower initial margin requirements compared to centrally cleared IRS

Contra swap futures:

  • No liquid market (yet)
  • Limited flexibility
  • Does not cover all required features / variations of an OTC interest rate swap

Given the uneven distribution of pros and cons there really seems to be a market for swap futures. It all depends on whether market participants will accept the limited flexibility and thus the imperfect hedging capabilities of swap futures in exchange for less cost and easier adoption. This will definitely be easier to achieve for short- and mid-term tenors than for 10y or even 30y tenors.
We are convinced that product managers at exchanges will continue to invent more and more features to bring swap futures closer to OTC interest rate swaps.

As the market evolves we will be able to make better decisions, but for now this should be considered a viable option and developments in that space should be closely monitored. All players, including exchanges, clearing houses, traders, technology providers and service providers will be impacted by that evolution and should prepare themselves to support upcoming developments by enabling quick time to market strategies.

Attempts to replace OTC derivatives with futures have been rejected in the past, but new financial regulation around the globe sets the perfect market opportunity this time to bring such new products to life. We are curious how the market will react. One thing seems to be clear by now already – OTC swaps and futures will converge as OTC swaps are getting more standardized while futures are getting more customizable.