Since the Dodd-Frank act was passed last year, new initiatives are being introduced to meet the legislated move from OTC to exchange traded contracts.

The interest rate swap market in particular has been a focus for innovation with a raft of new launches as the market anticipates a move towards central clearing and an increase in trading on organised trading facilities.

The decision last month by the CFTC and SEC to delay the introduction of new rules relating to interest rate swaps until December was met with relief by many in the industry who feared that US regulators would prioritise time over substance with their rulemaking.

However, when the CFTC and SEC finally pass down rules and definitions regarding the regulation of the interest rate swaps market, the seeds being sown now will come to fruition when the rules are introduced at the end of the year.

Preparation for the changing regulations has so far been subdued. According to a report by the Tabb Group, only 40% of firms have begun actively preparing for regulatory reform of the OTC derivatives markets.

The report found that the majority of respondents were waiting clarification on regulations before committing resources. The report warns that a likely result of the regulation will be higher collateral requirements and stringent reporting requirements.

However, while many predict that Swap Execution Facilities will be the ultimate winners in terms of trading venues in the new regulatory climate, exchanges and other infrastructure providers are readying their products and testing and launching new concepts in anticipation of the increased demand.

Changing markets

According to the Bank of International Settlement, at the end of 2010 there was $465.3tr of outstanding notional in OTC interest rate products, with almost 80% of that relating to interest rate swaps. Of that figure, research by the Tabb Group estimated that 65% was bilaterally cleared, a figure it says will fall to 25% by 2012.

One of the results of this trend towards central clearing will be higher costs as end-user firms will be required to post increased margin, perpetuating the challenge that many smaller end user currently face in accessing the interest rate swap market.

However, new methods for managing interest rate exposures are launching to meet the move towards central clearing and exchange trading, initiatives that will cut costs and open up the interest rate swap market to more participants as well as providing an alternative to SEFs.

This month London-based Plus Derivatives Exchange, a new launch from Plus Markets Group, will open for trading on its new interest swap index products.

The exchange offers access to fixed and floating interest rate swap exposure through contracts based on the FTSE MTIRS Index Series enabling investors to trade on interest rates from two to 30 years on a range of underlying rates, as well as enabling spread and butterfly trades.

The contracts will be cleared through LCH.Clearnet and have no expiry enabling trades from just hours to years. The indices are designed to correlate to moves in fixed and floating interest rate swap prices and are rebalanced daily to ensure the index represents the spot price on trades.

According to Plus Derivatives managing director Clive Connors, the new product will open up the swaps market to new participants. “Many potential market participants are barred from entering the IRS market whether down to credit restriction or regulations. This product opens up access to emerging markets and other potential participants.”

According to Connors, the product’s niche will be market participants looking to hedge short term exposure to interest rate swaps at low cost, buying the index and holding it for a few weeks.

Eris gaining ground

Plus Derivatives will join the fledgling Eris Exchange, which was launched last year with a futures product designed to replicate the standard fixed vs floating three month Libor based IRS.

Eris Exchange spot starting interest rate swap futures are designed to provide the flexibility of un-cleared OTC interest rate swaps with the security of cleared futures contracts that are marked to market on a daily basis.

The contracts are simplified and standardised interest rate swaps with fewer variables than OTC swaps but enough variation to enable users to hedge relevant interest rate swap exposure. The product is traded through Eris’s SwapBook platform either as request for quote, CLOB, or block trade orders and cleared centrally through CME Clearing.

Kevin Wolf, managing director of Eris Exchange, said: “An interest rate swap has tens of variables, many of which have little economic impact. We have frozen many of those variables to allow for the benefits of standardisation which include transparency and aggregation of liquidity.

“We believe that a large proportion of interest rate swaps are executed as standardised structures, and many of the customised trades can and will be executed in a standardised format without loss of required flexibility.”

Trading on the exchange began in August 2010 and, as of June 17, contracts totalling $33.2bn had been traded with open interest standing at approximately $900m. On May 18, Eris Exchange launched its electronic trading platform which offers a central limit order book with streaming, executable quotes which are cleared at CME concurrent with execution. Eris SwapBook also has a Request for Quote module.

The exchange has filed an application with the CFTC to become a Designated Contract Market, which will allow for margin offsets with other CME futures and potentially lower initial margins. Wolf predicted that these developments along with upcoming new product offerings will drive increased volumes.

Exchange traded interest rate swap products are not a new concept. Both CME and NYSE Euronext offer listed futures products designed to replicate the IRS yield curves but both face challenges in providing exact replications of the IRS.

Interest rate products have maintained strong volumes during periods of historically low interest rates and volumes will soar as central banks tighten monetary policy in the face of rising inflation. That coupled with regulatory pushes to on exchange or SEF trading will reward innovators.

The challenge for Eris and Plus is how they face off competition from SEFs but with both targeting new markets in their strategies, it is likely there will be room for them in the growing IRS market.

Wolf is bullish about the challenge: “SEFs represent potential competition in that a user may choose to execute an OTC swap on a SEF rather than trading Eris contracts. However, SEFs may also be partners who provide an additional venue for trading Eris contracts, assuming they are licensed to market futures. Others may simply choose to carry our live market data as it will represent benchmark swap futures prices. “