Derivatives Rules Have Swaps Users Eyeing Shift to Futures
06/27/2012| 05:15am US/Eastern
By Katy Burne
Regulators' push to make derivatives markets safer is having an unexpected side effect: it is encouraging some financial institutions to rethink how they manage risk and consider experimenting with alternatives to privately traded derivatives called "swaps."
Any migration from the existing $600 trillion-plus market for swaps into more cost-effective and transparent futures contracts threatens to put pressure on banks' profits at a time when their trading revenue is already falling, thanks to weaker trading in credit derivatives.
The prospect of reducing transaction costs by eschewing traditional swaps also could encourage institutional investors to simplify their hedges, potentially exposing large users of swaps--pension funds and the individuals they manage money for--to losses because futures aren't precisely matched to a firm's risks.
"Conversations with market participants suggest that a whole host of client types are evaluating plans to go directly to the futures market to satisfy their hedging needs," said Alex Kramm, exchanges analyst at UBS.
In response to the financial crisis, regulators plan to require banks and other trading firms to push swaps into independent clearinghouses, which guarantee the trades for a fee. Until now, swaps users have dealt directly with each other, raising potentially market-freezing concerns if one side was unable to make good on its financial commitments.
Clearinghouses can help the swaps market by removing much of that "counterparty" risk; the drawback is that the clearers' fees could make some swaps uneconomical when the rules take effect, as early as the end of this year. Many investors haven't previously had to post upfront payments called "initial margin" to backstop their swaps, but under the clearing mandate they will have to.
Some investors have been exploring the idea of hedging their risks with off-the-shelf futures, which may not exactly cover their risks but would be less expensive than tailored swaps. A few are even considering wholly new instruments called "swap futures," that seek to meld the features of both over-the-counter swaps and listed futures.
Swap futures promise the cash flows and tailored elements of existing swaps, which institutions use to hedge or bet against everything from swings in the price of materials to interest rates, but are traded and cleared like standardized futures transacted on exchanges.
Supurna VedBrat, co-head of e-trading and market infrastructure at BlackRock, the world's largest asset manager, said the prospect of higher swaps-trading costs has her company considering its options.
"Given the uncertainty of the overall cost for swaps, there is a possibility that swap futures, either existing or new contracts, gain momentum as a viable alternative," she said, adding that with the right level of liquidity support, BlackRock would use some of them for a portion of its investment flows.
Eris Exchange, a start-up, has interest-rate swap futures, as does CME Group. (>> CME Group Inc). Other exchanges also are looking at these hybrids: CBOE Futures Exchange, a unit of the company that owns the Chicago Board Options Exchange, is creating swap futures allowing investors to bet on changes in stock-market volatility. TMX Group of Canada (TMXGF, X.T) is exploring swaps futures for the Canadian dollar interest-rate market.
TABB Group recently interviewed 31 investment firms and said 18 of them would start using instruments in the futures market if the new regulations made swaps too expensive to trade. Four said that they would alter their trading strategies by looking at more "vanilla" derivatives like futures or standardized swaps. Two of those four firms said they would become less active in swaps as a result of the clearing rules.
To be sure, such a new risk-management shift comes with risks of its own. State Street Global Markets believes any move into futures at the expense of swaps could affect liquidity and force a rethink in investors' overall trading strategies because of what those swaps have been hedging. Charley Cooper, senior managing director at the State Street unit, said a pullback from swaps could rock the market for corporate bonds, for example, if investors start using even fewer credit derivatives to insure against debt defaults.
Also, an exemption for certain corporations that use swaps to hedge routine business risks--as opposed to speculation for a profit--may saddle those companies with additional costs anyway because they might trade with dealer banks that are covered by the new rules.
"The exemption is a mirage because dealers that serviced those guys are still obliged to clear and will pass their costs on," said Will Rhode, director of fixed-income research at TABB Group.
One concerned company, Exelon Corp. (EXC), said in a regulatory filing on May 10 that "even if the new regulations do not apply directly to us, [its power plant subsidiary Exelon Generation] estimates that a substantial shift from over-the-counter sales to exchange cleared sales may require up to $1 billion of additional collateral."
TABB estimates that companies would have to set aside $1.6 trillion to meet clearinghouse margin requirements under the new rules. For those reasons, some in the markets believe that firms will not migrate from swaps permanently even if market participants expand the use of futures and nurture the introduction of new products like "swap futures."
James Wallin, senior vice-president in fixed income at AllianceBernstein, which manages $400 billion of assets, said he didn't believe any migration out of swaps into futures would be permanent.
"This is not the end of the swaps market," he said. "While at the beginning people will use alternatives such as futures, because collateral and margining will take a while to figure out, in the long run the rules will foster more growth in swaps."
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