SWAP FUTURES – A REAL ALTERNATIVE?
[NB this article is sponsored by Danske Bank Markets and NYSE Liffe] Swap futures are not entirely new, but they do claim to offer a ‘regulation- ready’ solution which meets the regulators demands to move OTC trading on-Exchange. Danske Bank Markets has ﬁrst-hand experience as market makers for NYSE Liffe’s Euro Swapnote® futures contract. Lass Hoejlund, head of derivatives and ﬁxed income trading at Danske Bank Markets spoke to Best Execution and outlined the arguments for using this derivative contract.
NYSE Liffe claims their contract, the Euro Swapnote®1 future provides an “open, efﬁcient and regulation-ready means of gaining Euro swap market exposure”. What is it replacing, how does it work and what differentiates it from other swap futures?
We’re all aware that swaps traded OTC are currently being pushed towards CCPs for clearing by the regulators. NYSE Liffe Euro Swapnote® is an exchange traded, cleared derivative future, which is in addition price transparent. You can look up the price directly on the exchange, which as a client means that you are not subject to individual bank preferences when constructing their swap curve. The futures price holds this information. Furthermore the Swapnote® future has cash settlement. This means you don’t need a large swap operation to actually trade the Swapnote®. Swapnote® futures are priced from the swap curve. There is a one-to-one relation between the price on this exchange-traded future and an OTC IRS swap. It is essentially the same thing, and it is a better hedge than the Bund, Bobl, and Schatz2 futures, since there will be no swap spread risk. For risk managers working with hedging a derivatives book and actively managing the duration and credit risk of the book, this is an extremely efﬁcient way of managing your risk. You would typically trade futures on the German government curve, Bunds, Bobl and Schatz. But by doing so, you often create a credit spread risk between the credit- and the government curves in your book. Euro Swapnote® helps get the relevant exposure and avoids the spread risk in the hedge. In addition, some of your trades against the portfolio would typically be interest rate swaps traded OTC. With the Swapnote® contract you get the same exposure, but instead of taking an OTC derivative on the balance sheet – one that is not easily removed again – with the Swapnote® you can open and close your exposure a lot more easily. As it is a future, it always trades on the same start- and end-dates within each IMM period.
What traction are these contracts gaining and with whom?
Interest in swap futures has increased substantially in recent years and we’ve started to see an increased interest from clients wanting to trade the Swapnote® future. We mainly see interest from clients who are already actively trading the Euro swap market, want to trade a more transparent product and are looking to keep their trading costs to a minimum. These clients are banks, proprietary trading ﬁrms, and end-users. In 2013 the turnover in Swapnote® has been rising steadily. We expect traction to increase further as mandatory clearing for swaps come into effect and many market users consider the beneﬁts of swap futures. We also expect more market makers to sign up and back the contract. This will give tighter prices and increased liquidity, which in turn will lead more clients to use the contract actively on a daily basis.
What is the role of the market maker in the value chain?
The market maker is helping to give this contract the attributes that the market is looking for in a futures contract. These are a tight bid-offer spread, an attractive liquidity to the price and transparency. If successful, a futures contract like the Swapnote® will eventually become “self-sustained” where one client is trading at another clients price. The market maker helps get this process underway. Today the Swapnote® price you can observe on the exchange is a combination of market maker pricing and interest from clients as well as other non market maker banks. The market maker is only needed up to the point where the Swapnote® contract can stand on its own liquidity. It is our job to help the contract get to that point.
How does the Swapnote® contract ﬁt into the trading strategy of Danske Bank?
Can you make any comparison with other instruments? Being one of the leading market makers in the Euro swap and government bond market, the Euro Swapnote® ﬁts in very well with our Euro rates strategy. Market making the Euro Swapnote® not only helps us hedge our existing client swap ﬂow, but can also potentially increase our Euro swap market share and keep our hedge cost to a minimum. Danske Bank is the only Nordic bank with a focused EUR rates strategy. After Lehman, we broadened our focus from the Nordic area to include EUR rates, as we found that our strong risk culture could be activated to the beneﬁt of our clients in the EUR rates space as well. Everyone was scaling down at the time and contracting. We decided to scale up and leverage our existing value proposition. These are core capabilities that have rewarded us as the best derivatives house in the Nordic area. The EUR rates strategy has been a huge success. It has been proﬁtable for the bank and the skill-set we have built on the way is very hard for our competitors to copy. When NYSE Euronext was looking for an investment bank to help get their Swapnote® relaunched they were looking for someone with a strong EUR rates skill-set and high level technological capabilities. Post-Lehman, calculating an accurate real- time swap rate is not easy to do. Building a swap curve that was arbitrage-free took us three years, and being a market maker on the Swapnote® contract is one of many ways we can capitalise on our technological capabilities. If we succeed with this, the Euro Swapnote® could reach the same size as the Gilt future or greater, and we see a lot of regulatory tailwind that will help us in getting there.
What trajectory do you see these contracts taking and what obstacles are there to success?
The turnover in the contract is building slowly but steadily (see diagram). One of the key problems to solve is how to get the price tight enough to make it an attractive offer in comparison with the OTC market. The market makers can help this happen to some extent, but the ﬁnal ingredient is a combination of increased end-user interest and trading activity. This is the process that is happening at the moment. Competition exists and is coming from other exchange- traded initiatives, trying to do some of the same things that the Euro Swapnote® does. However, the Swapnote® contract’s advantage is that it is known by most market participants and has a reputable exchange behind it. In the US, Dodd-Frank regulation is pressing for fast implementation of SEFs (Swap Execution Facilities) when trading with a US counterpart. A swap traded on a SEF does some of the same things as the Swapnote® contract does, but it lacks the price transparency that a future has and the cash settlement is more appealing to many clients.
Do you see further innovations in contract type as a reaction to regulatory change?
It seems to me that the Swapnote® contract is ahead of its time as the product was ﬁrst introduced some time before the increase in regulatory focus. An innovation that clients might be looking for in a few years’ time, is an increase in the number of maturities offered with the Swapnote®. Today it is traded in three tenors, namely two, ﬁve and 10 years.
1. Swapnote® is a registered trademark of ICAP plc and has been licensed for use by LIFFE Administration and Management. The Swapnote® contract design and algorithm are protected by patent (US 6,304,858 BI), owned by Adams, Viner and Mosler Ltd (“AVM”) and is exclusively licensed to LIFFE Administration and Management worldwide.
2. The Bund, Bobl and Schatz futures are all contracts based on underlying German Government Bonds. The Bund has a maturity of 10 years, the Bobl 5 years, and the Schatz 1 year.
Danske Bank Markets
Holmens Kanal 2-12,
1092 Copenhagen K
©Best Execution 2013