Swap Alternatives Fall Short as U.S. Swap Market Transitions

By Colby Jenkins, TABB Group

Originally published on TABB Forum

While fragmentation of global swaps liquidity appears to be abating somewhat, trading on SEFs in the U.S. has been slow to evolve. Meanwhile, though swap future growth has been steady, there still is no comparison between interest rate swap and interest rate swap futures liquidity. Ultimately, however, the higher costs of margin for non-standardized OTC swaps will be strong incentives for both European and U.S. firms to look to listed derivatives to hedge risk.

It was assumed that a growing divide between European and U.S. swaps liquidity pools would continue to expand, based on initial cleared interdealer interest rate swaps (IRS) data from ISDA. A hesitation on the part of global participants to do business with U.S. persons that are, as CFTC Commissioner Giancarlo recently put it, “branded with the scarlet letters of ‘U.S. person’” after implementation of mandatory swap execution facility (SEF) trading has been the driving force behind the trend.

Recent data published in ISDA’s report, “Cross-Border Fragmentation of Global Derivatives: End-Year 2014 Update,” however, suggests that while fragmentation certainly still exists, it has begun to abate slightly for Euro-denominated swaps – for now. Since August 2014, shared volume in Euro-denominated IRS between U.S. and European dealer counterparties has more than tripled after hitting an all-time low in July 2014, at which point 94% of global volume in Euro-denominated cleared IRS was exclusively traded between European dealers (see Exhibit 1, below).

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Source: LCH.Clearnet SwapClear, Cross-Border Fragmentation of Global Derivatives: End-Year 2014 Update (ISDA, April 2015), TABB Group

Prior to October 2014, when SEF trading first went live, the USD-denominated swaps market was a relatively even mix between shared volume (U.S. Dealer/European Dealer), U.S. Dealer/U.S. Dealer volume, and European Dealer/European Dealer volume, with all three buckets having normalized to contribute roughly one-third of total cleared swaps traded globally. During Q4 2014, however, shared volume between U.S. and European dealers grew dramatically. As of the latest available month of data, shared volume in USD-denominated swaps for the U.S. market is nearly double that of regionally biased volumes, peaking at 42% of global volume in December 2014 (accounting for 61% of the USD-denominated market specifically within the U.S.), while USD IRS volume traded exclusively between U.S. dealers or European dealers both fell during the same period (Exhibit 2, below).

Exhibit 2: Global Market for Cleared USD IRS, Notional Volume Market Share]

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Source: LCH.Clearnet SwapClear, Cross-Border Fragmentation of Global Derivatives: End-Year 2014 Update (ISDA, April 2015), TABB Group

Taking a step back, in terms of notional activity, the U.S. swaps market is still in a state of flux, pushed and pulled by regulatory influences and macroeconomic conditions (Exhibit 3, below). And any dynamic system subject to ever-changing variables will experience periods of ebb and flow. This certainly has been the prevalent trend over the past few years in the U.S. markets, especially in the case of interest rate derivatives.

Exhibit 3: U.S. Interest Rate Derivatives Market Monthly Notional Volumes (ex-FRA)

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Source: TABB Group, ISDA

Concurrent with an overall stagnant interest rate derivatives (IRD) market is a SEF universe that has been slow to evolve. After a lull in trading in the last two months of 2014, SEF volumes have grown in 2015, albeit only slightly. During Q1 2015, average daily notional SEF volume traded for IRD achieved consecutive monthly records in February and March. March set the all-time record monthly average daily notional traded (ex-FRA) at just under $164 billion.

[For details on recent developments in the U.S. Interest Rate Swap market, market share and volume trends within the SEF trading landscape, and emerging liquidity dynamics between European and U.S. regulatory regimes, please contact TABB Group for information on our recent report, “U.S. Swaps 2015: Paradise Lost?”]

Now that the once-threatened overhaul in OTC swap workflow has become a reality, market participants either will have finalized or begun the process of embracing the new paradigm, or taken steps to find alternatives. Looking to the collective Interest Rate Swaps Futures universe, a product that headlines have heralded as the principal contender for the traditional IRD market, growth has been steady but limited (Exhibit 4, below).

Exhibit 4: Interest Rate Swap Futures Volumes and Open Interest, CME DSF & ERIS SF (Jan ’13 – March ’15)

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Source: CME Group, ERIS, TABB Group

In notional terms, there is still no comparison between interest rate swap and interest rate swap futures liquidity. Looking at average daily notional trading volume, interest rate swap futures volume typically still accounts for only a fraction of a percent of IRD notional volume – meaning the market, while expanding, is not a viable alternative. Nonetheless, volumes and open interest in CME Group’s deliverable Interest Rate Swap Futures and Eris Exchange’s Interest Rate Swap Futures have grown significantly since 2013 – indicating that market participants are increasingly interested in testing out these waters until reliable and homogenous liquidity across contracts emerges.

An eventual rise in interest rates may serve as a catalyst for the next wave of conversion, as a rate hike and return of volatility will have new implications on capital resources for firms facing much higher Value at Risk (VaR) calculations. This ultimately will result in higher costs for end users of traditional swap products, and with that, the appeal of listed alternatives will likely grow. The lower VaR multipliers and margin treatment for futures contracts will become more persuasive compared to OTC alternatives.

Within Europe, where central clearing will be mandated across the board next year, margin considerations are also front of mind. For European buy-side firms relying on interest rate swaps as a risk management tool, the range of margin treatments based on their hedging preference (choice of swap) is a heavy burden to consider. Margin treatments for non-standardized OTC swaps are based on a 10-day VaR treatment, while standard vanilla OTC swaps are accessed on a five-day VaR basis and listed derivatives only a two-day VaR treatment. These treatments within the European regime are similar to those within the U.S. in which swap futures are calculated on a two-day VaR as opposed to a five-day treatment for swaps. Ultimately, the more specific the hedge, the higher the cost. These rules will be strong incentives for both European and U.S. firms to look to listed derivatives for more economic risk management exposure as the global OTC market overhaul carries on.