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Swap futures and interest rate exposure management

The timing was perfect. Just as the annual ISDA conference took place, media began to highlight the huge change in capital requirements resulting from the combined EMIR and Basel III provisions on exposures to central counterparties.

In addition, the European Supervisory Authority on 14 April 2014 published a consultation on the risk management requirements for non-cleared derivatives.  Now that the clock is finally ticking towards mandatory clearing of standardized interest rate derivatives and the dash towards reporting is behind us in Europe, you’d expect to see a pause in activity. But there’s no time to rest. Now’s the time to think about how to optimize.

Three key factors come into play when considering optimization:

-          Choice of product

-          Choice of execution/clearing venue

-          Collateral optimization

Cost of participation is increasing substantially. No surprises there. Optimization of your collateral management and a more dynamic approach towards sourcing and transformation is surely one of the levers. But how about the futurization of the swaps market? The difference in initial margin requirements between a futures based product and clearable swaps should help avoid performance drag by managing down your collateral needs. Clearing fees will probably fall as well.  Swap futures may provide a substitute for using swaps for at least a part of your interest rate exposure requirements. It is certainly a promising alternative that may help you in keeping costs under control.

Swap futures have been around for what seems like forever but never really delivered on their promise. But now new products are emerging, with development centred on:

-          Ability to physically settle

-          Widening choice of maturities

-          Fixed rate set at contract inception rather than standard for the series

-          Constant maturity products to allow more accurate matching of liabilities

Even with these developments, swap futures won’t completely address your needs for bespoke structures for hedging interest rate exposures. Nor for expressing a view on where interest rates are heading. However, there may now be good reasons to add the product to your arsenal.

As of now we are facing an 8-15 month period up to the formal introduction of mandatory central clearing for standardized products. Now is the time to see if such an addition is worthwhile. This leaves sufficient time to address the necessary set up issues and migrate part of your needs to futures from day one. This avoids the incremental costs of bilateral or cleared swaps.

Questions that will need to be answered include, but are certainly not limited to the following:

-          Does the product fit my trading/hedging needs and what basis risk remains?

-          Which product from a specification perspective best suits my needs?

-          Am I set up to execute on the exchange either directly or through a broker?

-          Can my trading environment handle the product from a booking and settlement perspective?

-          Can my risk management models deal with futures possibly settling into swaps?

-          Do I believe there is sufficient liquidity in the product from day one?

-          How does the product fit with demonstrating hedging effectiveness?

-          How do I evaluate the business case?

So, there is plenty of work to be done ahead of the launch date of mandatory clearing, which might take place as early as December 2014. Even if you believe you are all set up, double check to see whether the choices you have made so far are really the best ones, or whether you should reconsider the alternatives.



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