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.

Strengthening the Chain

Supply ChainSmall to medium sized enterprises (SMEs) play a critical role in supply chains in Asia. While these companies are important drivers of growth in the region, they face major challenges when it comes to obtaining finance. The SWIFT Institute funded the Malaysia Institute for Supply Chain Innovation, part of the MIT Global SCALE (Supply Chain and Logistics Excellence) Network, to research this issue. An interim white paper was published on March 10, 2013, and the final working paper will be issued in mid-2013.

Most countries are trying to create policy frameworks, regulations, financial institutions and rating agencies to promote the growth of SMEs, and it cites several examples. Yet there are myriad limiting factors.

On the demand side, lack of education, motivation and entrepreneurship prevents business owners from seeking finance to grow their business. On the supply side, it’s hard for financial institutions to get accurate and detailed information about borrowers. Borrowers lack the documentation, bills and receipts to prove they have the cash flow to repay the loan. They tend to rent or lease assets, so they can’t demonstrate that they have collateral to ensure against default. Credit rating agencies often are unreliable. As a result, when financial institutions do lend, they charge high interest rates. Other deterrents include high transaction and loan administration costs, legal bureaucracy and restrictions, and the lack of systems to enforce and monitor the rules for lending and borrowing.

Some innovative lending models have been introduced at the product, process and institution levels. The paper mentions India’s Kisan Credit Card (KCC) scheme to reduce the cost and the administrative burden associated with small loans. Other initiatives in that country include crop insurance, warehouse receipt financing smart cards and Self-Help Groups (SHGs). Thailand’s Bank, Agriculture and Agricultural Co-operative introduced the Joint Liability Group (JLG) to streamline screening, administration and enforcement.  Meanwhile, governments are increasing financial resources for SMEs and writing off their bad debts. Some banks offer low interest rate loans and have dedicated funds for agriculture. Additionally, NGOs and private organization are providing support in the areas of credit, market access and the development of SHGs.

Financial institutions can help their multi-national customers by supporting their supply chain. And by providing finance to SMEs, hopefully these companies one day will grow into bigger customers. However, developing products that meet their unique needs is only one part of the equation. It’s critical to support the financial reform process and help build the necessary infrastructure that will enable companies to thrive and compete.

  • What do you think are the major barriers to SME lending in Asia?
  • What can financial institutions do to alleviate these problems?
  • Is there anything in the new banking regulations (Basel III etc.) that help or hinder progress?