OTC vs. Futures markets - regulation as a catalyst

The regulation imposed on the derivatives space in the aftermath of the financial crisis is designed to create more transparency and reduce systemic risk -  particularly within OTC markets. The vast amount of unpaid debts accumulated in the years leading up to the crisis led to the realisation that the securitisation and transfer of risk associated with such lending had not been efficiently distributed, and had been completely underestimated by investors, banks, and rating agencies. As a liquidity shortage hit the wholesale funding markets, a short-term funding problem emerged for overleveraged banks. The opaque and previously lightly regulated nature of the OTC markets had created a perfect storm of interconnected risk.

The primary goals of the resulting regulation are now being implemented through central counterparty clearing (CCP) and trade execution venues. The first OTC derivative products to be mandated for central clearing are inevitably those which are most standardised, such as vanilla IRS and CDS on the more liquid indices and reference entities. The fear is that this will result in an increase in the cost of trading OTC swaps, especially when we note the more stringent collateral requirements associated with such trades. If you then consider the added requirement to execute trades on central venues, it’s hardly surprising that people are beginning to eye up the futures market as an attractive alternative.

Some of the large exchanges are doing just this; Chicago Mercantile Exchange, Eris Exchange and The Intercontinental exchange have all recently launched futures on swaps contracts. The result is what has become known as swap futurisation. In essence, this is the migration of derivatives trading from the OTC swaps market into the futures market. This phenomenon works if the end user of the product takes the view that in general any package of risk that can be structured via a swap can also be structured using futures and option contracts that can be traded in the futures marketplace.

What will become the defining feature of the futures market compared to the new OTC marketplace is not the product’s risk profile, but the regulatory rules. Historically the OTC marketplace was less regulated, lacked price transparency and was void of central clearing – meaning that the vast majority of derivative trades were OTC. Consequently, it has given many regulators, including the U.S. Commodity Futures Trading Commission (CFTC) significant pause for thought.

The rules around each market are given perspective by the values at stake. CFTC Chairman Gary Gensler recently stated that the open interest of swaps is a staggering $250 Trillion versus $30 Trillion for the futures markets. What’s more, in addition to lower margin requirements, the use of futures allows market participants to decrease the nominal volume of their swaps, potentially allowing them to avoid registration as Single Dealers (SDs) or Major Swap Participants (MSPs) with the US regulators.

In saying all of this, cleared OTC derivatives can still pose an attractive option. Bilateral and cleared OTC swaps allow parties to hedge risk exposure to a greater degree of precision that is specific to their balance sheet needs. Hedging risk using futures may require a package of financial instruments to hedge the same risk that a single highly negotiated and customer-specific swap can hedge.

Over the next 12 months it will be interesting to see how the prices of futures on swap futures contracts compare to their cleared OTC equivalents, thus indicating the amount of basis risk perceived by the market. If the basis is significant, then buy-side end-users that use hedge accounting rules may fail those rules because of increased basis risk where futures are used.

In reality, it will probably take about a year to eighteen months after the commencement of central clearing of OTC derivatives for users of the products to understand enough about the relative merits of them over the new futures on swaps contracts to make informed decisions on the best products and execution venues. What we know for sure is that whether or not regulators intended it, the wheels that have been set in motion are starting to change the market landscape, giving market participants plenty to think about.