If over-the-counter interest rate swaps didn’t exist, and a product was invented today to do the same job – knowing what the market knows about the Dodd-Frank Act and Basel III – it might look a lot like the Eris Exchange swap futures contract.
As a future, it’s subject to lighter margin requirements – clearing houses can calculate initial margin requirements over a one-day period for futures rather than the five or seven days used for OTC trades – and can be netted with existing futures positions (www.risk.net/2192354). For the Eris contract, that means offsets can be calculated against interest rate futures a firm has cleared with CME Group – in aggregate, a $37 trillion pool of contracts as of April this year.
In addition, exposure can be added or subtracted by going long or short the same contract – the position is collapsible – whereas OTC trades stand alone, each attracting new clearing fees over the life of the transaction, and making it more complex to run risk management and margining calculations. It also helps that firms have the documentation, technology and credit lines to trade and clear futures already, while thorny problems facing the OTC market – like how to allocate block trades among a big asset manager’s various sub-accounts – have already been solved and automated in the futures market. Last but not least, as a future, it’s not subject to Dodd-Frank Act rules on reporting, business conduct or execution.
“It’s not a foregone conclusion that cleared OTC swaps will be a viable product given the embedded unknown cost, so for BlackRock – looking a little way forward – we also need to have some alternative products, and this is one we think has been designed well,” says Supurna VedBrat, co-head of the market structure and electronic trading team in the portfolio management group at BlackRock in New York.
The reason the Eris contract has not taken off – despite being launched in September 2010 – is that OTC interest rate swaps do already exist, and the big dealers are trying to ensure this vast market survives the transition to the new regulatory regime. In the meantime, none want to support a product that competes directly with their existing business, leaving Eris’ five founders – all Chicago-based futures and options trading firms – as the contract’s sole liquidity providers. That picture could soon change.
“The OTC product has been a very profitable business for the sell side. In return, the buy side has been afforded the luxury of immediate risk transfer – for which we have been more than willing to pay”, says VedBrat. “But given the new rules that are coming in, the market structure is going to change and some of this liquidity risk premium is going to shift to the buy side, similar to equities. There is now more willingness, on both the buy and the sell sides, to think about new constructs that are going to emerge in the market. The clearing mandate is the catalyst incentivising this move from the bilateral world.”
VedBrat says BlackRock has been asking dealers to start quoting Eris swap futures – and she believes a handful of banks are close to signing up. A senior derivatives trader at one of those institutions – an international bank – adds that other big buy-side clients have also been pressing dealers to embrace the product.
“We think it’s a very interesting service. It’s well-constructed, with many advantages for both us and our clients. Dealers don’t have to wait for OTC clearing technology to come online, and can achieve netting benefits with their existing futures positions. Clients get the same netting and clearing advantages, and they get anonymity, so you can trade in and out very easily. In addition, the service was very carefully designed to completely mimic the cashflows and economics of swap markets, so you really don’t sacrifice anything,” he says.
The last point is critical if Eris is going to win round OTC swap users. Each Eris contract represents a notional amount of $1 million, the value of which is based on the difference between fixed- and floating-rate interest payments over the term of the contract – two, five or 10 years. In the parlance of OTC markets, the buyer of an Eris contract is the fixed-rate payer, while the seller is the fixed-rate receiver.
The settlement price of the contract at any point in time is determined by taking a value of 100 and then making three adjustments designed to replicate the behaviour of an analogous cash-collateralised OTC swap. The first is the net present value of future cashflows, the second represents the cumulative fixed and floating payments that would have been made in an OTC swap since the start of the contract – recalculated on a daily basis, and indexed to three-month US dollar Libor. The third adjustment, which is subtracted from the sum, reflects the OTC market practice of paying interest on received collateral at the relevant overnight indexed swap rate, in this case federal funds – a wrinkle that caught out an earlier attempt to launch interest rate swap futures by International Derivatives Clearing Group (IDCG) (Risk November 2011, pages 38–42). The three adjustments are condensed into a single settlement value, which drives variation margin payments from one party to the other.
Eris claims its contracts have the same sensitivity to a one basis point move in the swap curve – the DV01 – as a dollar cash-collateralised OTC swap and BlackRock’s VedBrat says the asset manager is willing to trade the product once liquidity providers and clearing members are ready. She adds that the Eris swap futures have a good pedigree: “Don Wilson, one of the main innovators behind this product, is well-respected, very smart – and we look to work with people of his calibre in defining what the new market structure is going to be,” she says. Wilson is the founder and chief executive of DRW Trading, one of the firms backing Eris, whose name is on the patent-pending method by which the Eris contract mimics OTC collateral-based discounting.
The international bank’s trader says his institution has already tested its ability to clear Eris swap futures and has worked out what’s required to quote the product, but further work is on hold while the industry races to meet upcoming Dodd-Frank compliance dates – a number of deadlines have been triggered by the swap product definitions that the Commodity Futures Trading Commission and Securities and Exchange Commission agreed on July 10 (www.risk.net/2191604).
So, that’s one. How many dealers does Eris need to draw in the buy-side firms? Not many, according to the exchange’s chief executive, Neal Brady.
“With this model, pricing is anonymous and the client’s main concern is having enough liquidity to get a trade done – regardless of who is providing liquidity. There are certainly enough dealers out there outside the top two or three that see the way the world’s going and want to move up the list. So we’re working with five or six dealers right now – some will be providing streaming prices, some will be doing voice execution,” he says. “We definitely need the sell side, but do we need the biggest of those firms, do we need all those firms? No – no way. And the buy side will tell you that.”
Brady’s right about the latter point, at least. “In futures, your execution and clearing counterparty are decoupled. If you get a handful of dealers providing sufficient liquidity, it will create the ability for the product to trade,” says BlackRock’s VedBrat. It could take as few as two or three dealers – in addition to the five Eris founders – to give the market a critical mass of liquidity, says the international bank’s trader.
Viewed that way, Eris is a door to the market’s future – and the first dealers through the door could end up stealing a march on the competition. The international bank’s trader says that is why the two or three leading dealers are wary of Eris: “Other banks that are trying to leapfrog to the top of the market are going to be in favour of anything that gives them more of an advantage.”
But even top-tier dealers recognise the Eris contract has some benefits. “They’ve got a shot. They’ve got a real shot. None of the dealers are going to say anything, but we’re discussing it internally – moving some of our volume over to their model,” says the head of derivatives clearing at one of the world’s biggest OTC market-makers. “But if you talk to any of the dealers, they hate them. The choice of name didn’t help.”
It’s not hard to see why – Eris is the Greek goddess of strife and discord, who was responsible for the argument that led to the Trojan wars.
A bloodless equivalent of those wars will play out over the next few years, as Eris goes up against a host of platforms offering execution of cleared OTC swaps – some of them using the same kind of order book-style trading the Chicago-based venture has settled on. With the OTC swap itself expected to become more standardised – possibly even to the extent that it will expire on fixed dates, like the Eris contract – the clear water that currently exists between the bilaterally traded product and Eris’ futures alternative may shrink, possibly undermining the contract’s advantages.
Eris’ Brady expects a lot of post-Dodd-Frank swap trading to migrate to the futures contract, but regardless of whether the exchange ends up being a big beneficiary of market reform, he says he’s certain Eris has the right vision – in other words, if it fails, it won’t be because the product was a bad idea.
“What we’re doing here is snapping in the third leg of the stool. The other two legs are cash Treasuries plus Treasury and eurodollar futures, which are deep, liquid markets that trade electronically – these things all price off each other, and swaps should be traded the same way. What’s been lacking is a market for that, but before you can have that kind of a market, users need to see standardised products that concentrate liquidity and offer the same exposure provided by OTC swaps,” he says. “Now, we believe it’s going to be Eris doing a huge volume of this – but one thing we’ll say unequivocally is this market will trade in this more standardised way over the next two, three, five years – there’s just no question about it.”