The notional volume of cleared interest-rate swaps (IRS) dropped significantly in 2015 through mid-March while the volume of uncleared swaps nudged up, perhaps indicating growing disfavor with the new swap-trading infrastructure introduced in the wake of the financial crisis.
Notional volume for cleared IRSs, typically favored by financial companies and those trading commodities, fell 26 percent to $17.891 trillion in that period, while the number of trades in those instruments fell by 1 percent, to 121,091. In the US, cleared swaps must now mostly be traded over swap execution facilities (SEFs) and cleared through one of a handful of central counterparty clearinghouses (CCPs), although that’s not yet the case for swaps traded in other jurisdictions.
Uncleared swaps, favored by most corporates seeking to hedge interest-rate risk, on the other hand, saw their notional volume increase 5 percent, to $7.322 trillion, while their trade count increased 25 percent, to 84,491.
The Dodd-Frank Act created after the 2008 financial crisis instituted clearing for more standardized derivative transactions and, to the surprise of much of the market, also required most cleared swaps to trade over SEFs. Trading on SEFs began in November 2013, and the first swaps were mandated to trade over them in early 2014.
Luke Zubrod, director of risk and regulatory advisory at Chatham Financial, said that among the several aims of the new swap regulations was the intent to create incentives to clear swaps in order to reduce systemic risk in the derivatives market. He prefaced his comments about the drop in cleared swap volume by noting he would expect regulators to be more concerned if uncleared swap volume had increased more sharply. Nevertheless, he said, the decline in cleared swaps does likely raise questions for regulators.
“Swaps don’t appear to be moving to the uncleared swap market, so the next question to ask is whether they’re migrating elsewhere, including the futures market,” Mr. Zubrod said.
Mr. Zubrod noted a report issued March 9 by Greenwich Associates, which used conversations with market participants and quantitative modeling, concluded that futures products will gain traction at the expense of more standardized cleared swap products over the medium and long term.
Although the number of cleared swaps barely moved year over year, the number of trades over SEFs increased by 12 percent. That increase is not hugely significant, and Mr. Zubrod noted the number of swap trades has little consequence from a hedging perspective, given one or four swaps can be used to hedge the same exposure.
Nevertheless, the increase in trades over SEFs will increasingly raise the question about whether the new electronic trading platforms are attracting high-frequency trading firms, Mr. Zubrod said. He added that Chicago-based Citadel, which has appeared as a liquidity provider in the SEF market, is also understood to be a high-frequency player in other markets, such as equity and exchange-traded derivatives.
Inquiring about the uptick in the volume of uncleared swaps with Chatham’s corporate and real estate teams, the former reported seeing no notable increase in interest-rate hedging. The real estate team said the increase may, among other factors, reflect anticipation of rising interest rates, and lenders’ interest in lending on a floating rate basis in order to limit their own interest-rate risk.
The drop in cleared swap volume may also simply reflect less willingness by market participants to deal with the US market’s complexity. J. Christopher Giancarlo, a commissioner at the Commodity Futures Trading Commission (CFTC), which instituted and regulates the SEFs, said in a January white paper that non-US swap market participants are avoiding the US swap market and its complex market structure and rules.
“Divided markets are more brittle, with shallower liquidity, posing a risk of failure in times of economic stress or crisis,” the paper says, calling for flexibility to allow for alternatives, such as Dutch auction-based approaches, that could eventually replace RFQs.