A future for swaps?
Pension funds facing new derivative-market regulation are increasingly willing to consider alternatives to traditional swaps, according to Cécile Sourbes. But the jury is still out on interest rate swap futures
“How much do we need?” Jake Moore, Gordon Gekko’s son in law, asks in the movie Wall Street: Money Never Sleeps. “Fifty, sixty million minimum,” the answer comes back. “And that’s just to hold off the current margin calls.”
It is no fiction that collateral requirements can swell quickly in over-the-counter (OTC) derivatives trades. Take account of the restricted type of collateral the bank will accept for those trades and a pension fund counterparty can find itself in a tight corner. Meeting margin calls will not become any simpler as the US Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) are fully implemented over the coming months.
Under these rules – which require central clearing of OTC derivatives – users of interest rate swaps will probably be required to post an initial margin to cover 5-10 day value-at-risk (VaR). For futures, by contrast, that can be as low as 1-day VaR: largely because the margin nets-off easily against that on other standardised listed products, and because futures are quicker to unwind in the event of default.
“Due to their sometimes highly customised profile and the bespoke maturity dates they offer, interest rate swaps appear more risky than highly liquid, standardised futures,” says Ben Larah, manager at the consultancy Sapient Global Markets.
European pension funds currently enjoy an exemption from EMIR’s central clearing requirements, but if they are sensible they will not be complacent.
“A bilateral swap is still the cheapest option for now,” says Thijs Aaten, managing director of treasury and trading at the Dutch pension fund manager APG. “However, looking ahead, if pension funds don’t have the clearing exemption anymore it all goes down to an economic choice: you’ll have an exposure to hedge and will evaluate the alternatives.”
Interest rate swap futures are not new but may now gain traction thanks to this new regulatory environment.
CME launched a new product in September 2012 and at the beginning of this year ERIS Exchange followed suit, tempting investors like APG with initial margin cost savings of up to 80% versus OTC swaps with its swap-futures standards. While both the CME and ERIS contracts trade quarterly and offer two, five, 10 and 30-year swap maturities, they otherwise present very different features.
“Swap futures have been around since the 1990s,” notes CME Group’s executive director for interest rate products, David Coombs. “The rationale was to develop a place holder for risk that swap traders could use. It was a sort of macro hedge that allowed you to put deltas into your book. Around 2002, both LIFE Exchange and CME launched a new round of swap futures – the cash settled swap futures contracts.”
However, Coombs concedes that those contracts had only modest success. At expiry participants’ delta dropped off their books and needed to be replaced by ‘rolling’ the position – selling a maturing future and buying a deferred one.
“Large holders of open interest often found themselves trapped,” Coombs continues.
“There was only one route for them, which was to roll, and they were captive to whatever market makers were on the roll.”
As the name suggests, CME’s new deliverable interest rate swap futures deliver the underlying swap at maturity, after three months. This almost answers the problem of potential negative roll yield: a pension fund can choose to take delivery, as long as it is also registered with CME by a CME swap clearing member, or it can sell its future before expiry.
“Our contracts are physically settled and keep a very hard link between the exchange-traded market and the OTC market,” Coombs points out. “If you don’t like the roll price, you just stop trading and take delivery.”
Nonetheless, given that a pension fund will probably use the future to avoid the margining costs associated with the cleared swap, it is unlikely to do that.
The ERIS standard products, by contrast, are available at the same maturities as the underlying swaps, and are cash-settled daily to the CME OTC swap curve. A pension fund never has to roll its position and rely on, or pay, the market a roll yield to provide liquidity.
“Our contracts relieve that pressure of the forced roll,” says Neal Brady, CEO of ERIS Exchange. “Clients have a choice to either roll the product quarterly or hold it to maturity. For example, a pension fund could take a position in an ERIS 30-year swap future and hold on to it as it rolls down the curve for 30 years.”
Another difference between the CME and ERIS contracts concerns the variation margin posted by each counterparty as the value of the underlying swap fluctuates, and ‘price alignment interest’ (PAI).
According to an OTC swap contract, variation margin is collateral so does not legally belong to the receiver – yet the receiver can earn interest on it, while the payer incurs interest to finance it. This is particularly advantageous for the payer of the fixed-rate leg of the swap future, who pays variation margin if rates go down (when it’s getting cheaper to finance it) and receives variation margin if rates go up (when it is more profitable to earn interest on it).
Furthermore, because of the greater convexity in longer-dated rates, these moves in the short-term deposit rate relative to the longer-term swap rate will always be in favour of the payer of the fixed leg of the swap future – the counterparty of the pension fund receiving the fixed rate. Over long periods, this advantage can compound significantly.
For this reason, for a clearable OTC swap a central clearing counterparty (CCP) will charge PAI to the receiver of variation margin, and pass it on to the payer, to even-up that advantage. However, futures, in which variation margin is a settled amount rather than collateral, do not generally include PAI.
This has previously caused problems: in 2011 Jefferies Group sued International
Derivative Clearing Group in the New York State Supreme Court, complaining that it was “fraudulently induced” to enter into futures that were not economically equivalent to the underlying swaps. Both parties agreed to a resolution through arbitration. ERIS has worked its own version of PAI into the daily settlement price of its futures to overcome this problem. At CME, only the underlying deliverable swap will be subject to PAI, and not the future – which means that exposure to interest-rate convexity will only last for the three months that you are in the ‘futures-versus-swap’ world if you take delivery, but the pension fund that continually rolls CME futures to maintain a long-term liability-hedging position will remain exposed as long as it trades. Coombs says the choice is the client’s, and it is important that they understand how the payouts of swap futures and OTC swaps compare.
Currently, the two swap futures both exist only on US dollar-denominated swaps, although both CME and ERIS are looking into similar offerings for Europe, while Eurex is at the design stage for a swap-futures offering.
But even if the products successfully cross the Atlantic, can they ever really be useful for Europe’s pension funds? “For those who have some very complex risk they need to hedge, there is no way futures contracts are going to be suitable,” insists Jeremy Taylor, specialist in operational processing and derivatives at the consultancy Rule Financial.
“There will always be a market for OTC contracts and even more, for non-cleared bespoke OTC products.”
Vanaja Indra, market and regulatory reform director at Insight Investment, also feels that swap futures would be “too standardised” to do the bespoke job of OTC derivatives.
“While we think that any innovation is good, we need to be aware of the fact that OTC derivatives do something very specific,” Indra says. “OTC derivatives create a hedge that is very accurate for pension funds’ balance sheets, whereas in the futures world, you don’t have this precision. If futures could actually do exactly that, then the OTC derivatives market wouldn’t have grown to the level it has.”
Nonetheless, others prefer to emphasise the importance of the innovation, and counter that the advantages of tailor-made swap hedging portfolios may be overstated. Aaten at APG accepts that a pension fund can try to eliminate any basis risk between its liabilities and its hedging assets by buying the specific interest rates for all of its individual liability maturities.
“However, that also implies that you would be trading non-liquid swap maturities,” he says.
An investment bank would willingly provide you with these swaps, he notes, but it would almost certainly attempt to hedge its exposure using more liquid contracts, incurring basis risk for which it will charge its pension fund counterparty a premium.
“In our opinion, if a bank provides this service to you, they will charge you for it,” Aaten reasons. “So it’s all about carefully weighing and considering your hedging strategy and comparing the basis risk versus the cost reduction, to see if you can achieve this by using [a range of] products.”
Nevertheless, one aspect of swap futures does concern Aaten. Even though initial margin requirements for swap futures remain much more appealing than those of an OTC swap, uncertainty remains around the type of collateral accepted. Aaten compares these initial margin requirements with those set under the central clearing system, which currently allows pension funds to post securities, as well as cash, as initial margin. Futures exchanges could insist upon cash, in which case the buy-side would certainly incur a significant cost.
“Posting cash as initial margin is expensive,” Aaten says. “That would go down to paying almost 50 basis points on top of the margin you post.”
This, of course, would go a long way to taking away any advantage of deploying interest rate swap futures rather than OTC swaps under the new EMIR and Dodd-Frank regimes.
Pension funds and their advisers are going to have to get much more creative if they want to stay in the LDI game – and we have seen an impressive amount of innovation to help them do it, with much more still to come. But challenges remain and no new product – or new spin on an old product – is the silver bullet that can make regulatory costs go away.