Eris Exchange’s rapid growth hasn’t been powered by nonfinancial corporate end users of derivatives, but that fuel may eventually come from companies hedging new bond issues and confronting increasingly burdensome swap regulations that don’t impact the exchange’s swap futures.
Launched in April 2013, the exchange surpassed $10 billion in open interest in February. Most of the volume was in its Flex swap futures contract, which provides customization and hedge accounting benefits similar to over-the-counter swaps. That’s still a drop in the derivatives-market bucket, although the growth in open-interest—indicating the products are used for hedging rather than trading–has been steady and rapid since last August.
Eaton Vance has publicly noted its regular use of Eris products, and Eris acknowledges the vast majority of the volume has come from banks and financial end users. However, corporate interest may pick up soon enough, now that issues related to trading on the swap execution facilities (SEFs) and reporting to the swap data repositories (SDRs) mandated by the Dodd-Frank Act have largely been dealt with, and end users can look for alternatives that facilitate hedging with fewer hoops to jump through.
In particular, said Kevin Wolf, chief business and product development officer at Eris, the exchange’s Flex product could be a boon to companies that issue bonds and swap them to floating rate.
Before joining Eris, Mr. Wolf worked extensively with such issuers in senior positions at the derivative origination teams at Bank of American Merrill Lynch and Lehman Brothers. He noted that to minimize the risks of swap spreads moving against them and liquidity drying up late in the day, corporates’ banks traditionally began locking in swap spreads prior to bond pricing. In effect, they traded the swap and the same-maturity Treasury bond on behalf of the client, generating the spread from their rate difference.
That typically happened several times before arriving at the final swap rate at the end of the day, when the bond prices. Prior to the arrival of Dodd-Frank rules, those multiple transactions were often time not booked, confirmed, and settled as discrete swap spread transactions, but now banks must document and settle each transaction and report it to the SDRs.
“Trading swap spreads means the banks must actually trade cash Treasuries with corporates. Many corporates may not be in the position to, be allowed to, or have the operational set up to trade physical cash securities, like long-term Treasuries. This is one area where things get tricky under the new regulations,” Mr. Wolf said.
The situation will be exacerbated when more swaps must be traded over SEFs.
“Once you trade the swap on a SEF, you’ve broken the link between the bond syndicate desk, where the banks manage the process, and the hedging itself,” Mr. Wolf said. “We’re not there yet because most swaps done by corporates don’t trade over SEFs, but we think that could change relatively soon.”
Corporates are concerned about the reporting of their swaps, including swap spread executions, because opportunistic traders will likely be able to link the reported swap transaction to the announced future bond deal, and determine just which company is locking in spreads.
Mr. Wolf said those concerns have been raised by corporates Eris has contacted. He added that Eris Flexes can be concurrently traded with cash treasuries or Treasury locks to mimic swap spreads with futures style reporting requirements that differ from SDR reporting, and without other hurdles stemming from swaps, when swapping a new bond issue to floating rate.
While cash treasuries can be difficult for corporates to handle, Treasury locks are common and user-friendly, Mr. Wolf said. The execution of these synthetic swap spreads can be done with the bank leading the bond syndication, without the risk introduced by trading on a SEF and introducing additional counterparties.
“Effectively you get the same economics that you had in deals prior to Dodd-Frank, with the similar execution efficiencies” Mr. Wolf said.