As regulations make over-the-counter swaps more costly forcorporate end users, exchanges are coming out with exchange-tradedswap futures contracts to provide an alternative. But the futurescontracts may never match the flexibility that OTC swapsprovide.

CME Group is launching deliverable interest-rate swap futures Nov. 13 that willprovide exposure to a cleared interest-rate swap, along with thepricing transparency, cross-margining and margin savings of astandard futures contract. The IntercontinentalExchange shifted allof its cleared energy swaps to futures last week, and it plans tolaunch a credit-default swap futures contract early next year.

So far, such products, especially those that hedge interest-raterisk, don't hold much appeal for nonfinancial companies.

“We are not even looking into these types of trades sincecustomization is critical for us,” says Tom Deas, treasurer at FMCCorp. and chairman of the National Association of CorporateTreasurers.

Futures contracts are typically standardized and carrypre-established fixed terms. OTC interest-rate swaps let companiescustomize maturities and LIBOR reset dates, and set amortizingvalues and other parameters. But the cost of using OTC swaps islikely to increase as new capital and margin requirements areimplemented.

“We think market participants, whether corporate or financial,will weigh the benefits of standardization compared to customizedOTC swaps, and each firm will decide what works best,” says JackCallahan, executive director and OTC product specialist at CMEGroup.

Capital requirements for OTC swaps under Basel III beginincreasing next year, and regulators have proposed calculating OTCinitial margin requirements using a 10-day value-at-risk (VAR)period, compared to only five days for cleared swaps and one or twodays for futures. Those margin requirements do not directly impactnonfinancial derivative end users, which are exempt from clearingand margin. However, financial institutions are likely to pass onthose costs to clients.

“Initial margin is probably the single reason why people look atswap futures and say, 'This is potentially exciting,' because theinitial margin associated with clearing is higher than futures,”says Luke Zubrod, director at Chatham Financial.

Futures standardization is the next bighurdle. Users must enter into CME's interest-rate swap futures, forexample, on specific dates in March, June, September or December.Callahan says that CME also offers weekly options on Treasuryfutures, which have been highly successful and provide someadditional hedging precision, and that its cleared swap solutionallows for customizing dates and the coupon.

Corporates haven't been a key target for the CME interest-rateswap future so far because it is standardized and corporatestypically hedge to exact dates, Callahan says. “There might come apoint where they decide to accept the basis difference between thedates of their debt and the dates of the swap future, because itwill be justified by the cost savings.”

Until then, corporate use of interest-rate futures is likely tobe limited. If a company needs to hedge a bond refinancing inApril, hedging with a futures contract that begins in March or Junemay mean they're unable to use hedge accounting, resulting in basisrisk that must be reflected in the company profit and lossstatement.

“This puts a strain on a company's accounting function theydon't want,” says Matthew Daniel, director in Citibank's corporatesolutions group, adding that since companies want to avoid hedgeineffectiveness in their P&L, they're likely to opt for morecustomizable cleared swaps and put up extra margin.

Wall Street, however, is seeking ways to reduce the issue ofbasis risk. Since starting operations in 2010, Eris Exchange has executed andcleared through the CME a notional $35 billion of its standardinterest-rate futures contract and a “flex” version that allowsusers to choose their transaction-entry date and coupon to a tenthof a basis point.

Michael Riddle, COO of the Eris Exchange, says companies thatneed to customize other parameters such the amortization scheduleor Libor index will still look to swaps. Dodd-Frank may complicateembedding such features into futures, Riddle says, but “if liningup dates between a bond issuance and the swap/future hedge is theonly limitation of existing futures that stops the corporate fromtrading futures, the date flexibility offered by Eris could be thetipping point for them.”

To the extent Eris Exchange's flex future enables customizableterms and alleviates the accounting and mismatching issues, saysCiti's Daniel, it should be attractive to corporates, although itmay take them awhile to see the benefits.

“I think it will be tough at first, since companies may resistany type of margining or posting of collateral,” he says. “Andthey'll certainly try to take advantage of the likelihood thatbanks may be slow to pass on Basel III charges on longer-datedderivatives, especially if the Basel III implementation is delayedin some jurisdictions.”

For more on this topic, see Derivatives Users Likely to See Higher Costs andSwaps Rule Sends Wall Street into Clearing Limbo.