Supply Chain Finance Business Higher on Asia-Pacific Banks’ Agendas

Wooden mannequins pushing puzzle pieces into the right placeAite Group recently conducted a survey in Thailand, Indonesia and Australia to gauge the current state of supply chain finance (SCF) adoption among banks operating in the Asia-Pacific region. It found that SCF business is now firmly on the agendas of Thai banks and is seen as a business generator for Indonesian banks. While it’s on the agendas of the Australian banks, technology isn’t perceived as offering the necessary support for SCF-related programs.

I asked Enrico Camerinelli, senior analyst in wholesale banking at Aite Group, why the Australian banks have that perception and exactly what they perceive as being the necessary support. He explained  that banks tend to look first at the products they can sell, and then at the enabling technologies to create the proper infrastructure. This is especially because enabling technologies (SCF enablers) usually don’t generate revenue for banks. Electronic invoicing, for instance, is an SCF enabling technology but banks typically can’t charge for it; it’s simply a cost of doing business. Not surprisingly, they’re reluctant to invest in a service they can’t subsidize, particularly in the current economic environment.

In countries where banks traditionally have assisted their local corporate clients in import-export trade-related business, SCF solutions are accompanied by other services that emphasize collaboration. Such services include supplier evaluation, supplier scoring, go-to-market support, lead generation, education on local practices and support in handling local administrative duties.

Interestingly, Aite Group’s study revealed that the domestic market conditions, economic dynamism and level of maturity in SCF awareness influence the decision to invest in SCF products versus services. When domestic market conditions show signs of growth, trends of economic dynamism are positive and the level of maturity in SCF awareness is high, banks should invest in SCF enablers/services. In the opposite conditions, banks should invest in SCF products.

One of the takeaways from Aite Group’s report is that software for SCF enablers is currently in demand from financial institutions in dynamic Asia-Pacific economies. As such, SCF software vendors have an opportunity to supply cash management, liquidity management and trade finance applications for building multibank collaborative platforms. These platforms allow corporate treasurers to have total visibility of cash positions and liquidity pools across all bank accounts. Additionally, they can exchange electronic invoices in any format, as well as issue payments from any bank account and in any format.

Aite Group’s new report is entitled Supply Chain Finance in the Asia-Pacific.

Alternative Exchange Technology: What’s Under the Hood

?????????????????????????????????????????????????????????????????????????????Nowadays, you can trade an array of assets on alternative exchanges, ranging from intellectual property rights and bankruptcy claims to tickets to sporting events. Recently, I spoke to Jim Downs, CEO of Connamara Systems, a company that provides technology to these marketplaces, to learn more about what’s under the hood.

Connamara offers a matching engine with similar functionality to what you’d find on any electronic stock or futures exchange. Buyers and sellers use a web interface to enter orders into a central limit order book, and when prices cross, trades are executed on a price-time priority basis. They also can view their positions and working orders.

Just about any alternative exchange can use Connamara’s solution. What’s really interesting is that Connamara can customize both the front and back end to meet the exchange’s unique needs. Additionally, when it licenses the trading platform and the matching engine, it includes the source code so the exchange can leverage their own development and IT teams in the future. Moreover, they can get up and running fast: it only takes about four to six months to implement the technology.

One Exchange Street, an alternative exchange for online bankruptcy claims trading, is in the early stages of launch. With Connamara’s technology as the foundation, its model is to provide price discovery and real-time trade execution via standardized claim transfer agreements to buyers and sellers of bankruptcy claims. The trading interface allows users to list, offer and trade their bankruptcy claims via the Internet. The back-office administration, claims verification and trade settlement functionality supports post-trade processing. Connamara also provides technical and operational support.

The front end needed to be customized because bankruptcy claims aren’t fungible. Let’s say a couple investors hold claims against two bankrupt companies. Although the claims are very similar and would likely be paid out at the same percentage, the investors can’t buy one, sell the other and have a flat position. They would have two open positions instead. Connamara customized the platform to have parent and child limit order books. That way, an investor could place a bid or offer on a particular class of claims at a given price, and it would be reflected in the order books of all the individual claims. It also set up the platform so users could find supporting documents pertaining to a claim, such as invoices submitted to the bankrupt company.

The Intellectual Property Exchange International (IPXI) is another alternative exchange running on Connamara technology. IPXI launched its first offering in June 2013 covering a portfolio of more than 600 patent assets – including 225 granted patents globally – related to organic light-emitting diode (OLED) technologies for display screen applications. Connamara customized IPXI’s platform so users could view patent and other documents relevant to the transaction.

Connamara also can customize the risk management functionality. For example, it can build in capabilities to qualify users to short-sell a cash instrument.

Additionally, the back end can be tweaked so settlement is manual or automated. One way of making settlement is to enable the money to change hands through an escrow agent with bank notification and have the funds deposited in a trading account. Processes can be put in place to handle payment defaults.

During the startup phase, it’s a significant challenge for alternative exchanges to attract liquidity and get participants that are accustomed to trading in a bilateral environment acclimated to exchange trading. (In fact, One Exchange Street is still seeking the next round of funding, so its official launch is on hold.) That’s all the more reason to partner with a technology company like Connamara so they can concentrate on establishing the core business.

On a final note, there’s plenty of potential for alternative exchanges — even in the consumer space. Football fans in the U.S. may be familiar with (Looking for holiday gift ideas anyone?) This site, which doesn’t run on Connamara technology, allows users to buy and sell forward contracts on tickets to college football championship games. If your team makes it to the finals, you’re obligated to pay face value for the tickets — plus you have to pay for the forward contract, of course. If your team doesn’t get to the championship, you lose the amount you paid for the forward contract. Payment and settlement is done through a major credit card.

When it comes to alternative exchange trading, the possibilities are endless. Come up with a good idea, and the technology is there to enable it.

Exponential Thinking

Speeding EarthRay Kurzweil has started about a dozen companies so far in his lifetime. He is a visionary, inventor, futurist and inspiring speaker. In his keynote speech at SIFMA Tech 2013 in New York in June, he shared some of his long-term predictions. His track record is pretty solid: 86% of the 147 predictions in his book The Age of Intelligent Machines were correct. Others were only slightly off the mark, like one that predicted we would have self-driving cars by now. They exist, but you can’t buy one yet.

Timing is critical to being successful as an inventor. You can’t plan your technology for the world that you’re looking at because if it takes a few years to get the project off the ground, it will be a very different world.

Yet the future is different than our intuition. Our intuition about the future is linear. By that, Kurzweil means that we anticipate things going at the same pace. While that’s true for many things, it’s not true for information technology.

The pace of change has been accelerating ever since we started creating technologies. Our first invention was a communication technology — spoken language — so we could collaborate with other people. That took hundreds of thousands of years to evolve. Stories began to vary between storytellers, so we invented written language to establish a permanent record. That evolved over tens of thousands of years. Then the printing press was invented over 500 years ago as a better way to produce written language, and that took 400 years to reach a mass audience. The telephone reached one quarter of the earth’s population in 50 years, while the cell phone did that in seven years. Social networks, wikis and blogs took three years. Now we see major changes in platforms, technologies and business models in one year.

The future isn’t predictable, but if you collect enough data and have the right visualization tools, you can make some educated guesses. Kurzweil realized that the fundamental measures of IT — price performance, capacity, bandwidth, and calculations per second, per constant dollar –  form a smooth, predictable trajectory that is exponential, not linear.

Take the genome project as an example. Scientists finished 1% of the project in seven-and-a-half years. Using linear thinking, at that rate, they thought it would take 750 years to complete. But the project was an exponential progression; it had been doubling every year. 1% is only seven doublings from 100%, so it was actually finished seven years later.

Every other aspect of treating biology as an information technology has continued to scale up in this exponential manner. The first genome cost $1 billion; we’re now down to a few thousand dollars. The amount of genetic data we collect keeps doubling every year, and we can now reprogram that information the way you would reprogram your cell phone.

Health and medicine has undergone a grand transformation from having been a linear process to being an exponential process. Some people believe Social Security will run out of money in 23 years, but their perception is based on linear models. They expect that there will continue to be extensions in longevity, but the models are based on the kind of progress we’ve seen during an era in which health and medicine was not an information technology. For financial professionals, this means a key assumption about the future that is built into instruments such as annuities, life insurance and long-term health insurance plans like Medicare is invalid.

The computer in a cell phone is several billion times more powerful in constant dollars than those used in the late 1960s. It’s several thousand times more powerful, it’s a billion times less expensive, it’s one hundred thousand times smaller.

“We’ll do both of those progressions again in the next 25 years. This [computer in a cell phone] again will be several billion times more powerful per dollar. It will be a hundred thousand times smaller. It will be the size of a blood cell, which gives you some idea of what will be feasible,” said Kurzweil. “But our intuition about the future doesn’t really fathom this kind of exponential progression.”

As price performance reaches certain levels, whole new applications become feasible, and that’s the driving edge of innovation. This can be said for everything from search engines to social networks. Social networks didn’t exist eight years ago because the price performance wasn’t there, he pointed out.

Kurzweil believes 3-D printing is going to revolutionize everything we care about. Already, doctors have scanned and imaged the throat of a girl with a damaged windpipe and used computer assisted design to create a virtual windpipe in the computer. They printed it with biodegradable materials, populated it with her stem cells, grew a new one for her in the laboratory and installed it surgically. This has been done already with tracheas and more complex organs like kidneys in animals.

The scale of precision is improving at a rate of 100 in 3-D volume per decade. By 2020, we’ll be able to print out an array of materials including plastic, ceramic, glass, metal and fabric and leverage the open source market to distribute free designs contributed by millions of people. Moreover, the open source market will coexist with high quality, proprietary products.

“We’re now in the quiet before the storm. This is a revolution that we can predict will happen,” he said. “Right now the precision is in several microns, but it needs to be sub microns for most applications to begin to revolutionize manufacturing. We’ll be there in a few years.”

Cloud technology is going to be another game changer. The mobile devices we carry around are extensions of our brain into the cloud. With minimally invasive surgery, Parkinson’s Disease patients will be able to have a tiny computer implanted in their body, which is connected into the brain. It will be possible to download new software to it from outside the patient. In the 2030s these will be the size of blood cells, and we’ll have millions of them in our body.

“Within 15 years, we’ll be adding more than a year every year to your life expectancy. So as you go forward a year, your life expectancy will move on away from you,” said Kurzweil. “That will be your tipping point. So if you can hang in there for another 15 years, you may get to experience the remarkable century ahead.”

Start Me Up

??????????????????????????????????????????????????On June 13, 2013 SWIFT held its Innotribe Start-up Challenge Showcase in New York. Innotribe is SWIFT’s initiative to enable collaborative innovation in financial services. Nine early-stage start-ups and five growth-stage innovators delivered pitches to an audience of leading angel investors, venture capital firms and decision makers. This September, finalists selected from the New York event will compete with finalists from showcases in London and Singapore at Sibos 2013 in Dubai.

Of the nine start-ups, I think these four have the potential to offer the most value to the financial services industry: P2P Cash, PeopleHedge, Realty Mogul and XYverify. All except PeopleHedge will be competing in Dubai.

P2P Cash

Banks typically don’t have branches in extremely remote regions, but the inhabitants have mobile phones. P2P Cash is a patent pending solution that enables individuals to send money to any mobile phone on the planet. P2P Cash intends to partner with banks, which will have an opportunity to earn revenue from foreign exchange transactions. Banks also can gain access to new customers who send money home regularly and are potential buyers of micro finance products. So far, P2P Cash has forged partnerships in the Philippines, Kenya and Nigeria and is working on deals in other countries including India and Mexico. The company competes with XOOM.


PeopleHedge offers simple risk management tools for currency hedging. Small businesses are exposed to foreign exchange risk, but bank products tend to be too large-scale to suit their needs. PeopleHedge enables to businesses to execute micro hedges (as little as $1) for a fee, and then it aggregates the risk into currency options. The company sees the potential to white label the product for banks, which can then use it to service customers who previously would have been unprofitable. Any type of company can use PeopleHedge, but there are industry-specific offerings that smaller businesses can use. For example, PriceLock enables companies to protect against fuel price spikes, and the Climate Corporation enables agriculture industry participants to protect themselves against the financial impact of adverse weather conditions.

Realty Mogul

Realty Mogul pools money online to buy shares in pre-vetted real estate investments. Essentially, it’s a crowd funding platform like Gust and Kickstarter. It’s designed for qualified customers who want to invest as little as $5,000 in various types of real estate across multiple geographies without the hassle of owning physical property. The entire investment process is done online including executing the legal documentation, and investors have access to a dashboard 24×7. Realty Mogul generates revenue through administration fees.


XYverify uses mobile phone tower technology to securely certify a person’s location and reduce the risk in financial transactions. Individuals go through a one-time registration process without having  to download special software on their mobile device. Its primary use is to reduce fraud, lower false positives and prevent account takeovers. It also can be used to send customer loyalty messages: for example, the customer can receive a message on their mobile phone when they walk into a branch or gaming facility. XYverify is on-boarding beta customers. The business model is to generate revenue through a flat monthly access fee. Customers can opt in or out at any time. To ensure privacy, they can set up geo-fences so they are not tracked within certain areas. As for XYverify’s competitors — Google recently announced a geo-fencing offering.

While I found these companies the most interesting, that’s not to say that the other five start-ups don’t have commercial potential. Here’s a snapshot of their offerings:


Based in Chile, AgentPiggy is designed to educate kids aged 6-12 years old about making better financial decisions through a technology-based on a virtual bank account. The kids can pick products they want to buy from an online marketplace, create a wish list and track their savings and progress toward purchasing those items. The business model is to provide education as a service. It’s subscription based for individuals, and schools can license it for a small annual fee. So far, AgentPiggy has partnered with the government of Chile, BBVA and Banco Estado, and it has some partnerships in Brazil as well. It is also exploring opportunities in Florida and Texas. The company competes with firms such as Playmoolah and Vitual Piggy.

Agile Credit

Agile Credit is an online direct lender for small businesses, many of which either can’t get credit or they’re unhappy with the credit arrangements they have. Traditional lenders simply can’t service many of these businesses profitably. The concept is to leverage information in the cloud to provide prompt online relationship lending and professional advice. Agile Credit provides the dashboard for free, and it charges interest on working capital, while managing defaults and retention.


GoodApril is an automated online tax planning resource for consumers and self-employed individuals. It provides a forecast of tax liabilities as well as intelligence to identify tax saving opportunities. Individuals can optimize their withholding levels, for example, while the self-employed can use it to track expenses, calculate quarterly payments and identify deductions. GoodApril pre-populates the tax return, reducing the amount of time it takes to file taxes. The company competes with H&R Block and TurboTax, but neither company has a tax planning solution. GoodApril offers a free version as well as a more sophisticated, subscription-based solution. Since it went live in March 2013, and it has signed up several hundred users.


LICUOS is a B2B payment platform that allows businesses to pay commercial debts, net payments and fund working capital in a cost-efficient manner. The solution is compatible with ERP, accounting and e-invoicing systems. It leverages proprietary patent pending technology and adheres to security standards as well as external and internal daily audits. The company’s business model is to generate fee income by providing an alternative to traditional banking. Among its competitors are PayPal and Intuit.


Most trades on exchanges are automated through algorithms, yet mass retail customers have little or no access to quantitative methods of investing. Quant firms typically require investors to put up $10 million or more. QuantConnect has a network of established quants who build and test algorithms on its platform. It then connects to brokerage accounts for execution. The company has raised money from quants working in the industry, it has partnered with leading data providers, and it is considering sales to hedge funds. It offers some basic services for free. Subscription fees range from $19 per month for “hobbyists”, $99 per month for “professionals” and $499 per month for teams of 10 engineers.

Good luck to all the Innotribe Start-up Challenge participants.

Trust: In On Foot, Out On Horseback

Rancher Leading Horse Through Snowy FieldI was chatting with a senior executive recently about risk management, and he made a poignant statement. He said: “Trust comes on foot and goes on horseback.” By that, he meant it takes a long time to build trust, but it can go away very fast.”

That comment made me think about how confidence in the financial services industry has been rocked over the last few years, and rightly so. If firms can’t demonstrate a strong ability to manage risk, then why trust them?

Financial firms have to monitor and manage an array of risks including information security, data theft, terrorism and business continuity. They also have a responsibility to prevent their employees and customers from engaging in market abuse and illegal activities such as insider trading and money laundering. The consequences of not managing these risks are onerous: regulators can impose steep fines, they can suffer damage to their reputation, and it could even destroy the firm.

Compliance has become a top priority financial firms, and they realize the importance of investing in technology and staff to perform this function well. Although it’s an incredible challenge to do, integrating various risk management systems is a powerful proposition that could have a positive impact on the firm’s operations and strategy.

Here’s just one example. Imagine the advantage of integrating the trade surveillance system with the governance, risk and compliance (GRC) system. Firms need to monitor trading activity and keep an audit trail on everything they do once their surveillance system sends out an alert. When the regulator asks how a firm manages its alerts, it can show them not just the actual alerts, but also the preventative actions and countermeasures that it took. To do that, it needs case management, workflow management, reporting, and dashboard capabilities in the GRC system that link to the trade surveillance system.

In a broader context, the aggregated information gleaned from the trade surveillance and GRC solutions is useful for identifying and monitoring trends. Going through many cases over the course of a few years may reveal an increase or decrease in a particular type of market abuse. That information could be used to enforce or change policies as well as alter systems or alert settings.

Managing individual exposures is tough enough, but gaining a holistic view of risk, turning it into intelligence and managing it enterprise-wide is one big hurdle to jump. Firms are working on it, but they still have a way to go.

More Personalized Banking Services, Please

Cisco Blog Photo #4For more than a decade, banks have been talking about how customers should be able to connect through multiple channels and have a consistent experience across them. They admit that they need to break their silos and design products and processes to deliver services anytime, anywhere. In the last few years, a new dimension has emerged: how do banks leverage big data to deliver personalized services consistently in real time across multiple channels?

Today’s consumers are digital savvy, and they’ve integrated social media into their lifestyle. As such, they’ll readily take advice from strangers, and they’ll openly share information that previous generations would consider strictly private. Our world is being transformed by data and enabling technologies that can exploit it. Capturing structured and unstructured data, turning it into information and driving insights from it is a source of economic value.

According to a recent survey by Cisco, 46% of consumer respondents in the U.S. believe that banks know enough about them to offer personalized services. Even more bankers (58%) feel that’s the case. Moreover, 69% of consumer respondents would provide more private information in exchange for more personalized service, higher security against identity theft and greater simplicity in managing their finances. 63% of the consumers surveyed said simplicity in managing finances (including budgeting) is very important.

Consider this example of how a predictive financial management tool from the bank can meet customers’ needs. Let’s say you set a goal to save 10% a month. The bank can help you achieve it by analyzing all the data they have about you and your spending habits. When you walk into a grocery store, the bank can push a recommendation to you on your smart phone based on your location. This time of the month, you generally spend around $300 for groceries. To meet your budgetary goals, you need to spend no more than $270. As you’re putting items into your shopping cart, you’re also getting a running total on your smart phone.

The survey showed that 34% of consumer respondents believe receiving real-time advice that would assist with financial purchasing decisions would be attractive. And of those, half said they would be interested in receiving it based upon their actual geographic location.

Consumers want a personalized mobile/online banking experience, but they still want branches, too. As consumers have moved transactions onto virtual channels, the number of  transactions in the branch can’t support the overhead of the physical premises. That’s why banks such as Wells Fargo and Bank of America plan to launch new branch formats that are one-third of the size of their traditional branches, but still deliver the same set of services. They can provide access to remote expertise through video information walls, larger screen ATMs with video chat and wireless technology.

Technology is the enabler, but good service is the key to success. We’re talking high availability, competence and efficiency. That’s the stuff that a positive brand image and customer loyalty is made from.

Dodd-Frank Reform: Wrestling Over Remaining Issues

Wrestling graphic

After years of wrangling and wrestling over financial services reform, Dodd-Frank is kicking into effect. In March, category one players started central clearing of OTC derivatives. Category two players come on stream in June, and category three starts in September. Moreover, we’re starting to get a better feel for how market participants intend to position themselves.

For example, GFI Group recently submitted an application to open a proprietary U.S. futures exchange. News reports say BGC is revamping ELX Futures, and ICAP may launch futures in London on ISDX (formerly PLUS). But what structure will these venues take, what are the benefits to launching a futures exchange, and how can these venues differentiate the contracts they list?

Firms can register as a Designated Contract Merchant (DCM) or a Swap Execution Facility (SEF). Dodd-Frank allows DCMs to list futures and swaps, whereas SEFs can only list swaps. The advantage of going the DCM route is the rules already exist, whereas the SEF rules don’t exist yet. The delayed rules are driving SEF wannabes like ICAP crazy because they’re spending a hefty sum of money preparing for launch without bringing in revenue to offset the expense.

What’s the holdup?

Under Dodd-Frank, trades have to be reported as soon as technologically practicable. However, reporting on block trades can be delayed so the liquidity provider has time to hedge the risk. As far as the CFTC is concerned, “technologically” means electronic, so trades have to be done electronically unless they’re a block. Yet there are other times when buy side firms just want to trade over the phone — a good example is in illiquid markets. And why not, as long as the call is recorded and the trade is reported in a timely fashion. One could argue the voice trading issue is pretty bogus, but that doesn’t mean it’s going away.

Then there’s the issue of RFQ 2 and RFQ 5. The CFTC said trading must be conducted on a central limit order book or through an RFQ process. If customer trade is being crossed, it has to be exposed to the market for 15 seconds. But should buy side firms have to show the RFQ to two or five dealers?

I recently spoke to Chris Ferreri, managing director at ICAP about this. He argues that the RFQ issue is a red herring, and it makes no sense holding up the SEF rules on its account. An RFQ can be as simple as “make me a market on 100 5s.” That RFQ doesn’t increase price transparency because there’s no price stated in it. There’s no direction either, because the buy side firm is asking for a two-way market. The RFQ includes an amount, but the buy side firm may have more to do. The maturity is transparent. The downside of the RFQ process is five dealers know that a buy side firm is looking to execute a trade in the market, and chances are the firm doesn’t want to share that information.

Back to the products

Derivatives traders will probably be able to choose from several flavors of OTC and standardized products — some will be look alike contracts and others will be differentiated. Ferreri points to a couple unsuccessful attempts to launch look alike futures contracts in the past: specifically, Eurex’s Eurodollar contract and BrokerTech Futures’ treasury futures contract. He blames their failure on the vertical model for trading and clearing futures contracts, clearinghouses’ unwillingness to accept contracts that compete with their own products, and the concern over lack of fungibility.

The concern about lack of fungibility is understandable for a physical futures contract. If a trader buys 10,000 bushels of wheat on an exchange, then that exchange is responsible for delivering 10,000 bushels of a specific quality wheat to a given location at a certain time. Contracts must be in place with farmers, grain elevators, railroads and truckers. In the case of a cash-settled financial futures contract, one could argue the fungibility argument is weaker because cash is fungible.

Finally, there could be battles over intellectual property because futures contracts are patented. For example, Goldman Sachs owns the patent on the CME interest rate swap futures contract.

Financial market participants don’t like lack of clarity, and they’re not particularly fond of change either. The sooner issues such as voice trading and RFQ 2/RFQ 5 can be resolved, the better. As for the venues and products that emerge and their potential viability – I guess we’ll just have to wait and see.


Big Data Gets Smart: It’s All Semantics

Computer Tape Backup StorageLike other organizations, banks are trying to come to grips with big data: a vast amount of data coming from many sources at a faster rate. At the SWIFT Operations Forum Americas conference in March, David Saul, senior vice president and chief scientist at State Street Bank, made an interesting point. He said he thinks in terms of “smart data”, which encompasses not only volume, velocity and variety, but also value.

Big data is problematic for banks when it comes to regulatory reporting. They have to calculate and report aggregated risk positions to multiple agencies, and they’re going to spend billions of dollars annually doing it. This exercise would be easier and more cost efficient if reports could be produced in the same format and transmitted in the same way to all regulators globally.

Pulling  information from disparate systems and platforms that have no knowledge of one another is a challenge. However, banks can use semantics to connect data in one place to data in another place in a similar fashion to the Internet. Essentially, semantics allows the data from the sub-units in an organizational hierarchy to be connected along with the meaning.

To this end, the Enterprise Data Management (EDM) Council has been working to create the Financial Industry Business Ontology (FIBO). A key piece of FIBO is the Legal Entity Identifier (LEI), which uses semantics to create a common identifier for a logical entity. A few years ago, the EDM Council began a collaborative effort to turn FIBO into a standard that maps to business needs and contains the correct meanings and relationships. An outgrowth of this initiative is the Smart Regulation subgroup, which is focusing on ways to standardize regulatory reporting.

By bringing data together with the semantic models, banks can prepare regulatory reports much quicker. Once the data is brought together, it doesn’t have to be mapped again, which saves time and money. Moreover, banks can start to query the same big data to make smart strategic decisions that ultimately generate revenue.

Interest Rate Swap Futures: Comparing Apples with Apples

Apples to ApplesAn upside of the new financial market regulations is that they can be a lever for innovation and an impetus to form new partnerships. We’re already seeing evidence of this happening with the futurization of interest rate swaps.

Both Eris Exchange and CME Group list interest rate swaps futures contracts based on IMM dates. Yet Eris’s swaps futures contracts compete with and complement CME’s offerings. Eris clears its swaps contract through CME’s clearinghouse and can portfolio margin with the CME deliverable swap future (DSF) as well as Eurodollar and Treasury futures. Moreover, Eris hopes to be able to offset margin against OTC swaps contracts, offering clients a full suite of portfolio margining.

The unique feature of CME’s contract is that it’s deliverable. If a position isn’t offset or rolled forward prior to the maturity date, it becomes a cleared OTC swap. The owner of the futures contract posts margin based on 2-day VaR calculation. If the position turns into an OTC swap, the owner posts margin based on a 5-day HVaR calculation.

The Eris offering is a differentiated product that always remains a futures contract. If a contract isn’t offset, it enters the effective period of the swap futures and the forward period. The margin continues to be calculated on a 2-day VaR in the futures guarantee fund.

Eris’s product accrues price alignment interest (PAI) for the life of the trade, and it settles to the OTC swap curve. For example, a firm that has a futures contract constructed as a 5-year forward period on a 5-year swap may receive PAI for all 10 years. If the firm did the same trade on the CME, kept rolling the DSF for five years (20 rolls), and then took delivery of the 5-year swap, it would have missed out on five of the 10 years of PAI. Practically speaking, the market would price that into the bid-ask of the contract, but the firm would still incur the spread as the contract is rolled forward.

The CME futures contract is priced in 32nds whereas the Eris contract is priced on NPV. This provides friction between the two products resulting in trading opportunities in both contracts.

Both exchanges list 2-, 5-, 10- and 30-year benchmarks. Eris also lists Eris Flex products, enabling firms to construct futures contracts to manage duration or match their cash flows. For example, they could combine a forward period with a benchmark contract to execute a contract with the maturity in 7 years and 2 months, 23 years or even 40 years. The Eris Flexes are akin to the CME OTC clearing offering following the 5-day HVaR margin methodology. The market may look to these complementary offerings as a switch market between traditional swaps and swap futures.

The category 1 central counterparty clearing mandate only took effect on March 11, 2013, so it’s still early days. It will be interesting to see how market participants change their behavior to dynamically formulate trading combinations between Eris Exchange swap futures and CME’s deliverable swaps futures contracts, and the CME cleared offerings.