True or false? In the post-EMIR landscape, insurance firms and pension funds are likely to face increased cost from mandatory clearing and margining of their interest rate swaps in order to hedge interest rate risks on their long-term liabilities.
Let’s see if the threat is real. Swap futures provide a greater degree of standardization compared to interest rate swaps. While the latter can be tailored to meet buy-side demands, the listed swap futures increase price transparency and reduce collateral
demand and core capital consumption.
Electronic trading also leads to standardization, greater ease of use, clearing through a central counterparty and reporting via a central trade repository for listed futures.
Reducing the cost of collateral
Swap futures also reduce the overall cost of collateral. The associated VaR (value at risk) calculation is based on a holding period of two days compared with five days for cleared interest rate swaps and 10 days for non-cleared swaps.
Assuming a normal distribution for the purposes of this discussion, the associated collateral cost might be up to 60% less than for cleared interest rate swaps. Furthermore, the reduced cost of collateral will also reduce the need for collateral transformation
services and associated costs.
Before swap futures can achieve momentum in the market, a number of challenges must be tackled. The liquidity of contracts in Europe needs to increase. While the US has seen a market develop in the wake of mandatory clearing of interest rate swaps, current
volumes in Europe remain low.
Sell-side institutions need to step in as market-makers. Additionally, there is some expectation in the market that ESMA (European Securities and Markets Authority) might modify the EMIR RTS (regulatory technical standards) to counter the difference in VaR
calculation between different products by aligning the holding period as required for both products’ VaR calculation.
Working on future swap products
Swap futures are not necessarily tailored to meet buy-side needs. For one thing swap futures expire every quarter, which means that contracts must be rolled each time they reach maturity. Eurex have announced that they are considering constant maturity swaps
for a future release.
This makes hedging long-term exposures a significant task for the back office. Additionally, certain swap futures are physically deliverable. Once delivered, the associated collateral costs for cleared interest rate swaps come back into play in order to
maintain the position. Various market infrastructures (e.g. LSE, Eurex) are reported to be working on swap future products, which will likely result in a wider range of product characteristics than are available at present.
Buy-side firms should start looking at their business case now, since clearing brokers are not likely to act proactively in the development and offering of swap future products. With heavy investments in interest rate swap clearing under EMIR in place, their
focus might be more on return on investment than on product development.
Additionally, existing fee structures for interest rate swaps provide clearing brokers with a steady stream of income. Taking the US market as a proxy, trading volumes in swap futures will probably pick up once mandatory clearing of interest rate swaps becomes
effective in Europe.
In order to profit from the benefits of swap futures, buy-side firms need to get up to speed as soon as possible and drive the ongoing market discussion in order to create a viable alternative in the interest rate derivative market.