Risk Management: Flex Futures Volume (and Viability) Grows
Although trades remain spotty, the Eris Exchange’s Flex interest-rate swap futures appear to be gaining volume as clearing deadlines pass, indicating the products may become a more viable alternative for corporate end-users facing increasing costs for over-the-counter swaps.
As of July 16, the 5,700 Flex contracts traded for the month comfortably exceeded the 4,550 contracts throughout June. Although still a relatively small number, Eris only effectively began trading the new futures contracts in April.
“As clearing deadlines have approached and the deadline for the category 2 round of market participants passed June 10, we’re starting to see market participants become more familiar with futurized swap products,” said Matthew Simon, senior analyst at Tabb Group.
Trading in the contracts was nevertheless spotty, with trades of 1000 or more Flexes occurring on four days, and nothing on the others. Each contract has a notional value of $100,000 and is cleared as futures by CME Clearing.
A number of factors suggest increasing Flex volume may continue. For one, deadlines requiring many firms to begin clearing, in March and June, were anticipated to prompt market participants to take a closer look at futures as an alternative. The last round of market participants required to clear, including some big corporates such as Microsoft, must be ready by September.
In addition, Eris recently began offering margin offsets between the Flex contracts and its Standards contracts, which in some ways resemble more traditional futures contracts but still replicate OTC swap economics. Kevin Wolf, Eris’s chief business and product development officer, said market makers will benefit dramatically from the offsets, but that should ultimately make the transactions more cost effective for all end users.
“That new level of margin efficiency for price makers will benefit all end users because it makes dealers much more aggressive in making prices,” Mr. Wolf said.
Another boon for Eris’s Flex product came from a FASB decision at the end of June to approve the overnight indexed swap (OIS) rate as benchmark in the US, making it easier to apply hedge accounting, a must for many corporates.
Eris’s patented design for the Flex future gives users flexibility in choosing dates and coupons, and they replicate the economics of a bilateral swap by synthetically passing the interest on overnight collateral from the net receiver of the collateral to the net payer. Margin is based on five-day value at risk (VAR), the same as cleared swaps and higher than the two-day VAR for Eris’s Standard contract and most other futures. However, it is half the margin for the uncleared OTC swaps that corporate end users typically use.
In fact, the Flex contract was designed to draw users of uncleared OTC interest-rate swaps. Corporates are exempt from clearing them, but new regulations including Dodd-Frank and the unfolding Basel III capital guidelines are anticipated to make uncleared swaps much more costly for banks to offer and thus more expensive for end-users, increasing the appeal of cleared products.
Tabb Group’s Mr. Simon said the success of the Eris and CME swap futures products is unlikely to be fully known until the third clearing deadline passes and September and swap execution facilities (SEFs), over which OTC swaps must be executed, are up and running by year end.
“We’re in the very early innings here, and we don’t expect a pick up until later this year and into next year,” Mr. Simon said. “However, we’re very bullish on the market opportunity. We see these products being used by market participants and doing well.”