By Dwight Cass

Will corporates make the move to exchange-traded swaps? 

Most major market participants in the $380 trillion notional OTC interest rate swaps market already have their contracts cleared by a central counterparty (CCP). The International Swaps and Derivatives Association (ISDA) estimates that about two-thirds of OTC interest-rate swaps are already being cleared, as dealers turn to CCPs in anticipation of being forced to do so by regulators. As of mid-2012, 54 percent of the OTC interest rate notional was cleared by CCPs, according to ISDA.

The value of the corporate exemption from interest-rate swap clearing in this environment will vary. The amount of basis risk and the importance of obtaining hedge accounting, among other factors, need to be weighed against the
expected rise in the cost of swaps, as dealers move to recoup the higher cost of regulatory capital on bilateral transactions.

All cleared

Dealers believe that only 20 percent of OTC derivatives will remain non-cleared after US Dodd-Frank and EU EMIR and MiFIR clearing and capital regulations kick in. Dealers expect that the cleared OTC market will resemble the bond market, with the majority of deals privately negotiated, publicly reported and centrally cleared.

To be centrally cleared, swaps have to have a number of attributes. They need to have a high degree of legal and economic standardization. And they need to be written with terms that are popular enough to attract sufficient liquidity for the CCP to hedge its book. If most OTC swaps are being cleared, they must be beginning to meet these requirements, and by becoming more standardized, they are becoming less useful as tools for companies that want to avoid basis risk and achieve hedge accounting. Corporates face the tradeoff between basis risk and hedge accounting on one hand and costlier bilateral bespoke dealers on the other.

The amount of basis risk and the importance of obtaining hedge accounting, among other factors, need to be weighed against the expected rise in the cost of swaps. 

A poll of The NeuGroup’s FX Managers’ Peer Group last year found that only half the members would seek an end-user exemption. (See “End-User Exemption Not So Sought After?” iTreasurer.com, September 18, 2012.) Even with the exemption, there are a host of headaches that treasurers will have to face; for instance, an exemption from clearing and even margining will not exempt corporates from the economics of the new market realities (see “Should Corporates Stop Banking on End-User Exemptions?” International Treasurer, September 2012):

1. They are not exempt from the new market norms;
2. The costs of exempt OTC transactions will need to be recalculated in line with those new norms;
3. Pricing exempt derivatives is going to get trickier; and
4. The exemption does not eliminate reporting and documentation requirements.

Rate of Future Rate Futurization

If OTC rate hedging becomes uneconomical or the regulatory bias headaches make it too risky, corporates do have some listed tools they can use already. Take the CME. The Chicago giant tried to roll out swap futures several times in the past, only to see the dealers strangle them in the crib. But now, dealers are more supportive—in part because swap spreads have narrowed so much that dealers are happy to get the products off their menu.

The Merc offers 5-, 7-, 10- and 30-year contracts, and rolled out deliverable swap futures in December 2012 at 2, 5, 10 and 30 years. These are delivered into cleared OTC interest rate swaps at expiration. Since their debut, open interest on the deliverable swap futures has averaged about $2.1 billion.

These products have a significant cost advantage, with margins about 50 percent lower than cleared OTC swaps. If a corporate uses Treasuries or Eurodollar futures for anything, it can offset margin on the swap futures against those products, reducing in some cases margin cost by up to 90 percent—although that would be more likely with financial accounts than corporates.

happy endings

Another advantage of the exchange-traded products is the ease of termination. A company simply sells the swap future on the exchange to the highest bidder. With a bilateral OTC deal, the end user has to either establish an offsetting transaction, or find someone to purchase the transaction—with the counterparty’s approval.

Dealers are more supportive because swap spreads have narrowed so much that they are happy to get the products off their menu. 

Futures may also be more forgiving of a company’s credit problems. Dealers traditionally do not charge initial margin on OTC bilaterally cleared transactions, seeing this as akin to a provision of appropriately priced credit. Dodgy companies can have their feet held to the fire by dealers on these transactions via pricing or collateral requirements. Exchanges charge initial margin and so are not obligated to analyze every market participant’s credit—and one important part of CCPs’ risk management is the diversification effect in its portfolios, which is one reason the clearing houses do not take on illiquid instruments.

Can’t fight the fed

Traders often quip that you can’t fight the Fed. When the central bank gets moving in one direction, you’d better get out of the way. Something similar might be said about the swap market. Regulators have proven themselves eager to intervene in the market to make exchange trading and central clearing more attractive. Corporates could soon have to find ways to deal with the nettlesome basis risk and hedge accounting problems that exchange-traded swaps can cause. After all, their clearing exemption won’t keep the rest of the world from changing.