A new breed of hybrid product that brings over-the-counter interest rate swap economics into the more capital efficient world of listed derivatives is set to go live at the end of July and is already generating support from end users.
Start-up exchange, GMEX, is currently putting the finishing touches to its euro-denominated Interest Rate Swap Index Average Constant Maturity Futures contract, which received UK FCA approval in December.
The success rate of new futures contracts is notoriously low, but the latest attempt at melding swaps and futures into a single product has already attracted investment from the likes of Deutsche Boerse and SG Newedge as well as price streaming agreements with Tradition and Tullet Prebon for the underlying index.
The latest seal of approval has come from potential end users that believe the constant maturity structure is more applicable than current deliverable and non-deliverable formats to address their hedging requirements – representing an estimated 85% of OTC interest rate swap volumes.
“They will give us access to truly diversifying risk exposure previously only available in the OTC space” said Guillaume Jamet, principal manager at Lyxor’s managed futures platform, Epsilon.
Old Mutual Global Investors plans to trade the new contract through its broker dealer network when new fund launches get the regulatory go-ahead.
“We have been looking for a more margin efficient alternative to interest rate swaps for hedging our new portfolios and believe that the GMEX CMF will more closely match our requirements than any other futures contracts currently available,” said Russ Oxley, head of rates and LDI at the firm.
He also noted additional benefits stemming from an agreement with Eurex to clear the new products, enabling use of collateral and operational processes already in place for existing Eurex fixed income derivatives such as Bund, Bobl and Schatz futures as well as Eurex’s own physically delivered euro swap futures contract.
“Buyside firms really see this as an alternative to OTC interest rate swaps for hedging purposes,” said Hirander Misra, CEO of GMEX. “We’ve built this product in dialogue with firms that haven’t really used alternative products as they aren’t closely aligned with the way that they typically use IRS for hedging.”
Hedging structure
At the heart of the issue is the difficulty in aligning standardised products that roll on a quarterly basis with bespoke hedging requirements. By marking to the exchange’s Constant Maturity Index on a daily basis, the CMF tracks the interest rate at the prospective tenor, allowing trading across the curve.
“The Constant Maturity Future offers a more granular delta hedge than quarterly rolling contracts and you can hedge every point in the curve,” said Misra. “A 10-year is always a 10-year so you centralise liquidity rather than getting lots of bespoke contracts that fragment liquidity.”
Demand for bespoke protection is something that Eris Exchange addressed with the Flexes version of its cash-settled swap future. The US-based bespoke product, however, attracts the five-day VaR margin of an OTC swap rather than the two-day margin associated with listed futures, including GMEX’s CMF.
Feedback from earlier versions of the swap futures concept highlighted concerns with futures style quoting and analytics that are unfamiliar to some users, so the latest instruments will trade with swap market quoting conventions.
“There has been a tendency to retro-fit interest rate swaps into the futures framework and that creates problems with the pricing format and analytics,” said Misra.
Awaiting a mandate
Even with buy and sell-side support, building early liquidity could still be an uphill struggle. Around six clearing brokers are expected to sign up ahead of launch, but there are no futurisation drivers yet live in Europe.
Mandatory clearing for OTC swaps under the European Markets Infrastructure Regulation has already missed numerous deadlines and is now anticipated in early 2016 for Category One clients. That means new participants won’t be caught in the net until mid-to-late 2016, while exchange-like swaps execution won’t take hold until 2017 as part of MiFID II.
The delays have caused frustration for providers of existing European products. ICE-listed euro SwapNote contracts have built open interest of just over 35,000 contracts since launch over a decade ago, while Eurex’s own Euro Swap Futures have yet to garner open interest across the four maturities.
In the US, where standardised swaps have been mandated for central clearing under Dodd Frank since 2013, it is far from clear that a widespread migration towards listed alternatives has occurred.
Eris Exchange’s cash-settled contract has built open interest of 176,000 contracts, with over 40% reflecting more bespoke Flexes contracts.
CME’s Deliverable Swap Future is currently has open interest of almost 90,000 across the four US dollar tenors, though the exchange’s euro-denominated contract, which launched last April, has yet to build interest.
