Much has already been written about the ‘futurisation’ of the swaps market. Initially this referred to the replication of an OTC derivative exposure using a futures contract, as was the case when ICE and CME switched their OTC energy products to futures.
However, the concept of futurisation has evolved and is additionally used to refer to the wider shift of trading from OTC products to futures. With the cost of OTC derivatives increasing, dealers are preparing for a shift in activity. Nevertheless, a broad-based futurisation of the derivatives market is not likely in the short-term.
The G20-driven reforms to the OTC derivatives market are designed to make the market safer and more transparent. While these changes will increase costs for OTC derivatives users, it is often overlooked that they will also lower the traditional barriers to entry such as credit ratings and legal documentation, allowing new entrants to access the market.
The increase in costs will come from direct fees, indirect collateral costs related to central clearing, as well as costs passed on to participants from increased capital requirements and leverage ratio constraints.
It is, however, far from certain whether these costs will trigger a market move en masse from OTC to futures. We may see a shift in products where initial margin (IM) levels are lower for futures vs. OTC (1 or 2 day vs. 5 day IM), but the capital requirement on the clearing members is risk-based regardless of whether it is a futures contract or OTC derivative.
Therefore, if the IM is lower for futures, the capital requirements for clearing members make it more likely they will request a margin multiplier on the futures positions. In practice, this would negate any potential headline IM savings, and means other factors will have to drive the process of futurisation.
Exchanges and clearing houses (CCPs) are preparing by creating OTC-style futures contracts; for example CME’s Deliverable Swap Futures and ICE’s CDS futures. These contacts are designed to have lower IM levels than their OTC equivalents to attract open interest. In addition, CCPs have built OTC clearing services to increase volumes across both futures and OTC products through margin offsets.
CME, which has almost all the open interest in US Dollar rates futures products, is offering cross margining of futures vs. OTC interest rate swaps. Similarly, Eurex, which has the majority of open interest in the German bond futures market, is planning to offer similar margin offsets.
Other clearing houses have yet to go public with their plans, although ICE is set to take control of LIFFE’s futures business as a result of its takeover of LIFFE’s parent, NYSE Euronext. LIFFE has significant open interests in Euro short term interest rate futures, and it is expected the company would have a plan to protect revenues by combining them with an OTC clearing service.
Clearing members are also preparing for futurisation by aligning their futures and OTC clearing businesses, often alongside prime services. In order for clients to enjoy cross product reductions offered by CCPs, they need to have their offsetting OTC and futures positions cleared with the same clearing member. By combining OTC and futures clearing at the same clearing member(s), clients should have greater bargaining power with respect to fees.
The most important participants, end-user clients, have to date keenly observed the latest developments and encouraged competition from the sidelines. Right now, clients are predominately concentrating on being compliant with new regulations for clearing and reporting, which will remain a focus in Europe and Asia until late 2014. Even in the US, where central clearing has already been implemented, clients continue to take a ‘wait and see’ approach.
The considerations of futurisation, such as margin efficiencies, the flexibility of OTC products compared to the standardisation of futures, collateral optimisation and liquidity concerns, will be more pressing once clients become familiar with the new operating models and the potential increased costs of OTC derivatives take full effect. At that point, the extent to which market futurisation is taking place will become more apparent.