Thursday, October 11, 2012

Exchange Traded Interest Rate Swap Futures

By Tim Dulaney, PhD

We've talked briefly about interest rate swaps in the past, but I wanted to write about a recent development in the securities industry that relates to these conventionally over-the-counter (OTC) instruments.

Back in the summer of 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act (PDF) was signed into law and as a result many OTC products have began the process of standardization in preparation for exchange trading.  The idea is essentially that exchange traded products offer a level of transparency and liquidity that are hard to find in the individualized and (sometimes) illiquid OTC market. 

Concurrent with this legislation, several Chicago financial institutions organized to form a new exchange (Eris Exchange, LLC) hoping to capitalize on the standardization of one of the most common types of OTC instruments: interest rate swaps (or, simply, swaps).  These bilateral agreements are used by nearly every segment of the investing population -- from individuals to banks, from school districts to hedge funds -- to alter the exposure of a portfolio to interest rates. 

In October 2011, the Commodity Futures Trading Commission (CFTC) designated "Eris Exchange, LLC [...] as a contract market." The Delaware limited liability corporation gained additional momentum recently through a highly-publicized investment by "State Street Corp. and Devonshire Investors, the private-equity arm of Fidelity Investments."

Eris offers a product comparison between OTC swaps and their exchange traded interest rate swap futures contracts.  In particular, their website notes that changes in the net present value of future cash flows are more quickly realized within the margin accounts of buyers and sellers.  As a result, investors can withdraw funds if their contract is overcollateralized, freeing funds for alternative investments. Furthermore, customers can realize up to 95% margin offsets through the mitigation of exposure with different futures contracts. 

For this exchange, clearing services are provided exclusively by the CME Group.  The initial margin levels are based on notional value of the underlying interest rate swap.  The exchange fees are per ($1MM notional) contract, charged to both the buyer and the seller, and depend on the tenor of the swap.

We here at SLCG are advocates of transparency and the establishment of this exchange could be a step in the right direction.  Although trading volume and open interest seems low now the CFTC recently said "over-the-counter trading in swaps and other derivatives, including about $465 trillion in notional worldwide interest-rate market activity, would be required to move to the public trading and clearing platforms by 2013." Only time will tell whether or not the Eris Exchange is "The Future of Swaps."

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