As regulations make over-the-counter swaps more costly for corporate end users, exchanges are coming out with exchange-traded swap futures contracts to provide an alternative. But the futures contracts may never match the flexibility that OTC swaps provide.
CME Group is launching deliverable interest-rate swap futures Nov. 13 that will provide exposure to a cleared interest-rate swap, along with the pricing transparency, cross-margining and margin savings of a standard futures contract. The IntercontinentalExchange shifted all of its cleared energy swaps to futures last week, and it plans to launch a credit-default swap futures contract early next year.
So far, such products, especially those that hedge interest-rate risk, don’t hold much appeal for nonfinancial companies.
“We are not even looking into these types of trades since customization is critical for us,” says Tom Deas, treasurer at FMC Corp. and chairman of the National Association of Corporate Treasurers.
Futures contracts are typically standardized and carry pre-established fixed terms. OTC interest-rate swaps let companies customize maturities and LIBOR reset dates, and set amortizing values and other parameters. But the cost of using OTC swaps is likely to increase as new capital and margin requirements are implemented.
“We think market participants, whether corporate or financial, will weigh the benefits of standardization compared to customized OTC swaps, and each firm will decide what works best,” says Jack Callahan, executive director and OTC product specialist at CME Group.
Capital requirements for OTC swaps under Basel III begin increasing next year, and regulators have proposed calculating OTC initial margin requirements using a 10-day value-at-risk (VAR) period, compared to only five days for cleared swaps and one or two days for futures. Those margin requirements do not directly impact nonfinancial derivative end users, which are exempt from clearing and margin. However, financial institutions are likely to pass on those costs to clients.
“Initial margin is probably the single reason why people look at swap futures and say, ‘This is potentially exciting,’ because the initial margin associated with clearing is higher than futures,” says Luke Zubrod, director at Chatham Financial.
Futures standardization is the next big hurdle. Users must enter into CME’s interest-rate swap futures, for example, on specific dates in March, June, September or December. Callahan says that CME also offers weekly options on Treasury futures, which have been highly successful and provide some additional hedging precision, and that its cleared swap solution allows for customizing dates and the coupon.
Corporates haven’t been a key target for the CME interest-rate swap future so far because it is standardized and corporates typically hedge to exact dates, Callahan says. “There might come a point where they decide to accept the basis difference between the dates of their debt and the dates of the swap future, because it will be justified by the cost savings.”
Until then, corporate use of interest-rate futures is likely to be limited. If a company needs to hedge a bond refinancing in April, hedging with a futures contract that begins in March or June may mean they’re unable to use hedge accounting, resulting in basis risk that must be reflected in the company profit and loss statement.
“This puts a strain on a company’s accounting function they don’t want,” says Matthew Daniel, director in Citibank’s corporate solutions group, adding that since companies want to avoid hedge ineffectiveness in their P&L, they’re likely to opt for more customizable cleared swaps and put up extra margin.
Wall Street, however, is seeking ways to reduce the issue of basis risk. Since starting operations in 2010, Eris Exchange has executed and cleared through the CME a notional $35 billion of its standard interest-rate futures contract and a “flex” version that allows users to choose their transaction-entry date and coupon to a tenth of a basis point.
Michael Riddle, COO of the Eris Exchange, says companies that need to customize other parameters such the amortization schedule or Libor index will still look to swaps. Dodd-Frank may complicate embedding such features into futures, Riddle says, but “if lining up dates between a bond issuance and the swap/future hedge is the only limitation of existing futures that stops the corporate from trading futures, the date flexibility offered by Eris could be the tipping point for them.”
To the extent Eris Exchange’s flex future enables customizable terms and alleviates the accounting and mismatching issues, says Citi’s Daniel, it should be attractive to corporates, although it may take them awhile to see the benefits.
“I think it will be tough at first, since companies may resist any type of margining or posting of collateral,” he says. “And they’ll certainly try to take advantage of the likelihood that banks may be slow to pass on Basel III charges on longer-dated derivatives, especially if the Basel III implementation is delayed in some jurisdictions.”