December 15, 2012


Are Swap Futures the Future?

Hedging interest-rate risk used to be pretty simple: a company would issue debt and simultaneously enter into a custom-fit, over-the-counter interest-rate swap with a financial institution. But the Dodd-Frank Act put an end to that simplicity. The law requires most OTC-traded derivatives contracts to go through a clearinghouse, so all transactions are handled by a central counterparty. Entering a centrally cleared swap will require a company to post margin, so companies will have to compare the cost of centrally cleared versus bilateral contracts.

The requirements haven’t taken effect yet, at least as they pertain to end users of swaps. But now, a large futures and options exchange is adding something else to the mix: futures contracts tied to interest-rate swaps that allow companies to lock in the terms of a swap for a future date.

CME Group, formerly the Chicago Mercantile Exchange, is launching “deliverable” interest-rate swap futures in early December. The instruments will have maturities of 2 years, 5 years, 10 years, and 30 years to start, as well as quarterly contracts. At maturity, the futures contract will convert into the underlying interest-rate swap of the selected tenor.

“If you buy a July 2013, five-year LIBOR fixed-pay futures swap, you have effectively locked in a swap spread for that future date, and on that date you will have a swap at the clearinghouse,” says Richard Paulson, managing director in the banking and capital markets advisory group at PricewaterhouseCoopers.

Swaps futures could be especially attractive to companies with low credit ratings, says Paulson. When such companies enter into a bilateral swap, they might be asked by the bank to post collateral or provide credit support anyway, he says. The cleared product could actually have lower margin requirements in comparison.

The CME says cleared interest-rate swaps and swaps futures provide distinct advantages. A listed market is highly transparent, for one. These products also eliminate bank counterparty credit risk and are much more liquid than OTC derivatives, says Sean Tully, global head of interest rates at CME Group.

“When a corporate does a trade with a single bank, it’s really a bespoke contract — not just on the date and the size, but on the two counterparties. So it’s completely dependent upon their creditworthiness,” says Tully. With a futures contract or a cleared swap, “you have a fungible instrument that you can get multiple parties to price if you ever want to exit the transaction,” he says.

To exit a bilateral swap, in contrast, a company would have to either enter into a contract that offsets the original OTC instrument or try selling the swap back to the bank or a third party. “In general, terminating the swap creates difficulty, friction, and increased costs,” says Tully.

An Imperfect Future
There are drawbacks to swap futures. For one, the end user would have to post initial margin as well as “variation” margin, a payment based on an adverse price movement in the futures contract. In other words, the position has to be marked to market daily.

Perhaps more important is the exposure to basis risk. With bilateral swaps, firms create something specifically tailored to their needs. But in a futures market, contracts are standardized, so the hedge and the underlying liability may be imperfectly correlated, creating the potential for excessive gains or losses from hedging. And there might not be a futures contract to match the desired time period for a hedge.

“The risk you’ll see in the interest-rate swap futures world will kind of mimic what you see in commodities, where some contracts — such as jet fuel or certain grades of commodities — just don’t exist,” says Gurpreet Banwait, a director of product management at derivatives risk-management firm FINCAD. In theory, using such an inexact hedge could disqualify a firm from using hedge accounting under Financial Accounting Standard 133, which requires that a derivative be “highly effective,” its value moving in a near-perfect inverse relationship to the liability.

The final rules on swaps from the Commodities Futures Trading Commission and other regulators will be a key input to what is essentially a math problem for corporations, says Paulson: Will the cost advantages of the listed futures or cleared swap product outweigh the financial and operational costs that come with it? How will those costs compare with the expected higher price of executing an OTC bilateral swap?

The sheer complexity of replicating a highly tailored bilateral swap with a listed product or products (a company may need to hedge currency risk with futures at the same time) may also scare off CFOs, says Paulson. Still, he says the interest-rate swap future is an interesting product: “It’s the type of innovation we are expecting more of since the regulatory bias favors listed and exchange-traded products.”

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