November 22, 2016

Listed Futures as Alternative to OTC Swaps

Over the past year, I’ve been speaking to buy-side UK and European clients and discussing issues they might not be aware of yet instead of challenges they are currently facing, with the aim to bring best practises from a variety of sources on the latest developments to incorporate in their business and add value; whether it’s trading practises, collateral optimisation or pre-trade total cost analysis (TCA).

Over the past year, I’ve been speaking to buy-side UK and European clients and discussing issues they might not be aware of yet instead of challenges they are currently facing, with the aim to bring best practises from a variety of sources on the latest developments to incorporate in their business and add value; whether it’s trading practises, collateral optimisation or pre-trade total cost analysis (TCA).

At first, I was interested in understanding which clients were Category 2 and 3 across Europe as I wanted to discuss their readiness to clear. I found a number of interesting outcomes, and for me, the most interesting were some clients actively reducing their OTC Swap exposure to below category 2 thresholds so the company / fund didn't have to comply with EMIR by 21st  December 2017. 

This was to allow time for looking at alternative products as a suitable hedge – as their finding showed the costs involved in trading OTC Swaps would create a drag on their portfolio.

I began to look more actively at what alternatives to OTC IRS and CDS products are out there and was made aware of Listed Swap Futures (LSF) and the different formats they come in; Constant Maturity Swap, Delivery Swap Futures and Cash Settled. 

The case for LSF are well documented, and some of the main advantages can be summarised as the following:

1. Lower Initial Margin

  • Lower margin costs associated with LSF results from the differing Value-at-Risk (VaR) periods verses traditional bilateral and cleared OTC Derivatives.
  • Listed Swap Futures benefits from 1-day MPOR (Margin Period of Risk) in the US and 2-day MPOR in Europe.
  • Cleared OTC Swaps are subject to 5-day MPOR (CME and EUREX) and 7-day MPOR (LCH).
  • Non-Cleared bilateral OTC Swaps incur the longest period, a 10-day MPOR.

2. Lower Capital Charges in favour for LSF.

The Potential Future Exposure (PFE) notional add-on under Basel III for futures is 0.5% while OTC products increase up to 1.5% for IRD and 5% for Credit Derivatives. Higher capital charges either effect participants directly or indirectly via the FCMs/Clearing Brokers, which in turn creates a drag of a client's portfolio and performance.

3. Trading Platforms

Trading takes place anonymously (without name give-up) with executable, transparent prices via an Order Book, meaning price takers such as Asset Managers and Pension Funds have the potential to hedge in the market without leaving their footprint for all to see.

4. Operations

The costs involved in trading, clearing and processing OTC Swaps in line with regulation is becoming a contributing factor in product selection. OTC Swaps need a Clearing Broker/CCP Agreement, ISDAs, CSAs (for bilateral), complex confirmations and allocations plus reporting to Trade Repositories.  Futures mainly need an FCM Agreement.


Changing Market Structure

I wanted to see what factors would need to change to accommodate LSF as a feasible alternative needed by clients.

Liquidity is considered the leading factor currently holding back the LSF Market. While open interest (OI) is increasing with companies like Eris Exchange recording record OI, it's important to be mindful of the changing market structure to fully assess it's longevity.


Increasing Liquidity Providers

Asset managers and price takers would be keen to see increasing liquidity via increased depth and range of market makers. Currently, higher commissions are normally generated by traditional OTC swaps market makers (such as banks) vs. exchange traded products and can be considered to be slowing the uptake. Instead, alternative firms are stepping up to be liquidity providers.

What should help traditional banks consider LSF over OTC swaps are the lower capital charges (as mentioned earlier) and resulting collateral that is freed up (from lower initial margin). This would act as an incentive in favour of LSF to those in charge of a banks overall strategy and balance sheet.


Current Clearing and Regulation Projects

Buy-side clients are still preparing for imminent projects such as mandatory clearing with a lot of time and resources currently invested. While these projects are in their final stages, clearing is limited to a small number of trades/funds ahead of their designated mandatory clearing deadline.

The buy-side are finding it challenging to even focus on newer clearing solutions (more direct clearing models), let alone consider new products irrespective of any potential benefits.  This is in addition to a variety of regulatory challenges that both directly (BCBS/IOSCO, UCITS V, AIFMD) and indirectly (IORP, Solvency II, G-SIB) affect them.


Focus on Optimising

What could be supportive to LSF, as the mandatory clearing deadlines pass, is a shift in focus to optimising trading strategies, ways to achieving best execution under MiFID II and time spent educating users on additional products.

There is near term scope that encourages smaller funds, both within larger buy-side firms as well as smaller firms themselves, to execute LSF as the cost of trading, processing and clearing OTC Swaps can impact these funds to a greater proportion. Clients find that in their larger funds, these costs are spread over a larger fund size and the portfolio drag is less prominent and obvious.


Delayed Margin Rules

Those with very directional portfolios, receive limited benefit from cross product margining, instead working on ways in the near term to reduce their initial margin, which could be considered time well spent.

With BCBS / IOSCO variation margin (VM) rules coming into effect at the start of 2017, the delayed phase-in period for initial margin (IM) implementation from March 2017 to 2020 only pushes out the impending impact and adds to the issue of early LSF adoption.


Exempt Clients

With European pension funds currently enjoying an exemption from EMIR's central clearing requirements until 2018, this can give time for the LSF market to increase its product range (to possibly include inflation products) and increase liquidity in more long dated maturities (that reflect the risk profiles required to hedge). 

Pension funds, in turn, should be mindful and not be complacent against early adoption.



Considering some of the main market structure factors just discussed, what could encourage clients to focus on Listed Swap Futures (LSF) as a viable product?

  • Firstly if they are happy the LSF matches the economics of an OTC swap, matches the risk profiles being hedged and favourable hedge accounting treatments achieved.
  • Time spent by exchanges and CCPs educating clients and new liquidity providers on how to trade, execute and book in their middle-ware/risk systems.
  • A shift in focus to optimising trading strategies and products 

This is complimented by the natural drive towards more electronic trading via MiFID II, which leads to standardisation of derivatives, and should be complimentary to the take up of Listed Swap Futures in the near term.

This article was first published in edition 8 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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