Streetwise Professor

February 2, 2013

Back to Futurization: The Consequences of Swap-O-Phobia

This week’s big derivatives story was about a public workshop at the CFTC on the issue of futurization.  I was one of the first people to comment on this issue, last year when ICE announced it was converting all of its energy swaps into energy futures.

That was Futurization 1.0. The conversion merely consisted of renaming “swaps” “futures”.  In all economic dimensions (contract specs, execution, clearing) the contracts remained identical.  But the renaming allowed some energy swap users to escape the dreaded Swap Dealer designation.

Futurization 1.1 was the CME’s conversion.  This illustrates some of the silly impacts of Frankendodd.  The CME has cleared energy swaps for going on 10 years now.  The parties would execute a swap, and submit the swap for clearing through an Exchange of Futures for Swaps (EFS) trade.  So the originally executed swap existed only until it was submitted for clearing, when it was replaced with economically equivalent futures contracts.  But no matter how short the swap’s life, the fact that it was born a swap meant that it counted towards the volume of swaps activity used to determine whether someone was a swap dealer.  So the process has now changed, and market participants use (mainly) block trades of futures to create the positions they want, thereby cutting out the interim swap step.

The transformation of the energy derivatives landscape, and the launch of swap futures by CME and Eris are now raising the question of whether futurization will spread beyond energy.

One motive to eschew swaps in favor of futures is unlikely to exist in interest rates, credit and other financial derivatives: the biggest market participants are likely to trade enough bespoke swaps for which there are no futures equivalents, meaning that they will be treated as swap dealers regardless: this reduces their incentive to substitute futures for swaps.

The main driver of futurization outside of energy will be CFTC regulatory treatment of futures and swaps.  Differential treatment will affect the economics of futures vis a vis swaps, and the prospect of such differential treatment was the center of controversy at the CFTC meeting, and in the larger debate in the industry.

The main sources of differential treatment are execution and margining.  Swaps will have to be executed subject to (allegedly) soon-to-be announced SEF rules, and are subject to immediate reporting.  Most market participants who will substitute futures for swaps will execute these deals via privately negotiated block trades subject to exchange rules.  Crucially, reporting of block futures trades is delayed 15 minutes, a concession to fears that immediate reporting would impair liquidity because block positioners (those supplying liquidity to the block futures market) could find it difficult to lay off their risk if the fact they had just done a big trade was announced immediately.  This would induce them to require larger price concessions for doing block trades.

Which raises the question: why the difference between the futures goose and the swaps gander?  Similar considerations obtain for swaps.

Thus, this rule difference is likely to favor futures executed via block trades as opposed to swaps executed via traditional means (but with immediate post-trade transparency) or via SEFs.  (Economically material differences between the rules governing block trades and SEF trades could also affect the relative costs of trading in these disparate ways, and hence affect the choice between them.)

Margining will be different for swaps and futures.  Futures will be margined assuming a one- or two-day liquidation period (i.e., margins will be based on something analogous to a one- or two-day value at risk).  However, swaps-even cleared swaps-will require a minimum liquidation period of 5 days for calculating initial margin.

This substantially higher margin for swaps results in a substantial economic disadvantage to these contracts compared to futures contracts that generate the exact same cash flows (in the absence of default).   This will likely be another factor pushing the market towards futures-which is a major reason for the fury of swaps dealers.

This differential treatment of economically equivalent contracts just because one is called a “swap” (BAD!) and the other is called a “future” (GOOD!) makes little-or no-economic sense-and reflects the swap-o-phobia that pervades DC, and which was an animating principle behind Frankendodd.

The reason to set margins based on a liquidation period reflects the purchase of IM: it is intended to cover potential losses on a defaulted position before that position can be liquidated by the clearinghouse (i.e., the position can be assumed by another solvent market participant).  The less liquid an instrument,  the longer it takes the CCP to work out of the position, the more it is exposed to potential adverse price moves and hence the more margin cover it needs.

This liquidation period depends on the economic characteristics of the contract, how widely it is traded in the marketplace, the identity, number and capitalization of the firms that trade it, and market conditions at the time of liquidation. All of these conditions should be pretty much the same for two contracts that specify the same contingent cash flows, one of which is called a swap and the other a future.  Consider say a 10 year vanilla IRS and economically equivalent futures contracts that offer the same contingent cash flows.  Abstracting from margining differences, these contracts have identical price risks, and should attract the same kinds of users.  Why should liquidity of one differ from the liquidity of the other in the event of the default of the holder of a big position?

And don’t tell me that futures are traded in light markets and swaps are traded in dark ones.  As already noted, futures traded as substitutes for swaps are and will be typically traded in blocks outside the limit order book.

More importantly: in the event of the default of a big FCM or dealer that should be the reason to be concerned, the CCP is going to try to get rid of the defaulted portfolio in big chunks through some sort of auction process.  The firm winning the auction will then trade out of the position, likely using the central market and block trades.

This isn’t much different than how a swap CCP will handle the default process.  Indeed, LCH obligates its members to assume portions of a defaulted portfolio, and one reason for having stringent CCP membership requirements is to ensure that the members have the capital and trading expertise to manage big pieces of defaulted portfolios.

We actually have a case study of futures and swap default management processes.  When Lehman defaulted, CME auctioned off its interest rate, equity, currency, commodity, and energy positions.  These trades were done at differentials from market prices, to reflect the risk that those taking over the positions would assume and have to work off.  A couple of the positions were under-margined: the firms taking over the positions required the CME to provide more funds than the Lehman margin it had against those positions.  As it turned out, the other positions were over-margined, and across all positions the over-margining exceeded the under-margining, meaning that the CME clearinghouse did not suffer any loss as the result of the default.  But this illustrates the possibility that futures can be under-margined, and that even the putatively more liquid futures contracts can require substantial price concessions to get someone to assume them.

LCH.Clearnet handled the default of the Lehman IRS positions. These totaled $9 trillion in notional-bigger than the Lehman futures positions at CME, and arguably far larger in terms of risk.  ($1 trillion in notional of a 10 year IRS poses substantially more risk than $1 trillion in notional of Eurodollar futures.)  90 percent of the position was hedged within a week.  According to LCH.Clearnet, the costs of trading out of the defaulted position were “well within” the Lehman margins it held.

It’s hard to see much of an economic difference between the CME and LCH experiences.  It doesn’t appear that it was materially more difficult to manage the default of “swaps” than it was “futures.”   The Lehman default does not provide any evidence that swap-o-phobia is anything but a mental illness.

Further, this case study illustrates that there is no reason to believe that absent government regulation, swaps will be under-margined and futures will not.  Indeed, had the Lehman positions been held at 5 separate CCPs, two of them would have been under margined.

Indeed, there are serious reasons to be concerned that government regulations of the margining of economically similar (and in some respects identical) contracts will create systemic risks, rather than mitigate them.

The margin regulations-with larger IM imposed on swaps than futures-are a form of price control, in this case default risk price control.  And we know that price controls work out swell, especially when applied by regulators in a two-sizes-fits-all fashion across all different kinds of instruments posing different risks and cleared by CCPs with potentially disparate financial strength.

Moreover, this price control will tend to induce activity to move towards futures CCPs.  Whereas in the absence of the margin differential clearing activity in, say, interest rate derivatives would be split between futures CCPs and swap CCPs, under the differential regulation, business will tend to tip to the futures CCPs-most notably, CME.  This will tend to lead to greater concentration of credit risk.

Wasn’t the whole point of Frankendodd to reduce concentration? Just asking.

The whole conceit that regulators can set risk prices is quite dangerous, and is likely to be a source of systemic risk because these prices are set on the basis of highly limited information in a politicized process, and because mistakes in setting risk prices (especially price differences between similar products) tend to lead to crowded trades and risk concentration that is highly destabilizing during crisis periods (cf. Basel II).

The case for setting different margins (default risk prices) on very similar-and in some cases identical-derivatives contracts is particularly weak.  It is the characteristics of the products and those who trade them that will drive liquidity and liquidation periods: products called “futures” that share the same economic characteristics as products called “swaps” will pose virtually the same challenges to liquidate in the event of a large default.  Given this, the economics suggest that imposing differential margins based on a name difference-rather than economic differences-can’t make things better, and could well make them worse.

But the Sorcerer’s Apprentices know better. So futures are likely to get an artificial advantage, and swaps an artificial burden. Such distortions are quite dangerous.  My conclusion? Futurize in haste, repent at leisure.

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    Pingback by Streetwise Professor » Back to Futurization: The Consequences of Swap-O-Phobia « The OTC Space — February 2, 2013 @ 4:24 pm

  2. [...] The future of swap regulation. [...]

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  3. You’re missing a huge point when comparing the default experience of LCH and CME. One took a couple of hours. The other took three weeks. This is due to the lack of standardization (large number of line items due to the infinite number of combinations of coupon/maturity/etc. With swaps).

    Comment by CF — February 3, 2013 @ 5:26 pm

  4. @CF. CME took 3 days-they say they *could have* done it in a day. The amount of risk in the Lehman LCH book much larger. $1 notional 10 year IRS equivalent to $40 notional EDF. If that risk moves to CME via futurization it will have the same challenge as LCH: that’s the main point. Moreover, the ability to customize is one of the advantages of the OTC market. LCH.Clearnet took that into account when setting margins, and they set margins so that the loser truly did pay. GiGi somehow knows better what the optimal tradeoff between customization and collateral cost? Not buying that. At all.

    The ProfessorComment by The Professor — February 3, 2013 @ 5:36 pm

  5. From the point in time when the decision was made to liquidate to when it was complete was hours, not days.

    LCHs timeframe was 100% due to operational issues, not market risk (it was a fairly well hedged D2D book to begin with). The firms couldnt load all of the trades in to be able to bid on the auction portfolios (multiple currencies).

    Don’t mistake this as me disagreeing with you on broader points.

    Comment by CF — February 3, 2013 @ 7:35 pm

  6. The central quantum of this debate is whether the simplism of picking a number of days by instrument type really works when it has been adequately demonstrated that some (but by no means all) swaps can readily be reconstructed as economically identical (not similar – identical) futures both in energy, FX, credit default and interest rate markets. Judgments can be made both in theory and based on a limited amount of practical experience.

    In practice, the most extreme scenario to date was Lehman’s default:

    - CME took 3 days longer than 1 day (from beginning of Monday to sometime Thursday) and 2 of 4 asset classes were undermargined. Suggesting 1 day was not enough time in any event and 1-day 99% VaR IM was inadequate. (Worth noting that CME has set its deliverable IRS future margin at 2-day close out a factor of approx. 1.4x what it would be if it were 1-day close out). The other point to note is that CME had no material swap futures on it’s books at the time of the Lehman default. How long it would take to close out those products is not evidenced.

    - LCH hedged 90% of Lehman’s cleared IRS in a week but presumably not the other 10%. However, the default was “comfortably within” Lehman’s own IM. Some evidence that IM assumptions in combination were robust though the 5-day parameter is somewhat in question given 10% remained unhedged after the theoretically alloted 5 days was up. Worth noting that LCH sets its LIFFE futures clearing margin as 2-day 99.7% confidence interval.

    In theory, a margin model can never encompass any avoidable extreme scenario as for any model based on a set of extreme scenarios – more extreme ones can be imagined where the margin is inadequate. Therefore, there is a balance to be struck between initial margin covering a large majority of bad scenarios and relying on other safeguards (guarantee fund, CCP capital, further cash calls on clearing members, close out of the CCP etc.) to cover the rest.

    Default management procedures can arguably be improved but the margin model should really assume these are efficient enough to be immaterial in economic effect (i.e. market liquidity itself should be the driving factor of the close out period). Market liquidity levels are simply not clear for the new swap futures as trading is so light as to not provide real evidence. Until and unless these are shown to be significantly more liquid than vanilla clearable OTC swaps these products should have a margin model that is at least as conservative as swaps (and arguably more conservative).

    Where does this lead? Perhaps we end up in a situation where swap futures (and maybe some other less liquid futures) have initial margin models set on more conservative close out periods or other margin factors. (At least arguably these should be back tested to show adequate margin so that all 4 asset classes in the Lehman default were individually adequately margined). This could mean bucketing futures into several margin close-out classes (1-day, 2-day, 5-day etc.) in separate clearing accounts (each margined separately).

    What about risk netting and margin offsets? Where there are asset classes which span more than one margin close out classes in order to obtain the offsets an approach could be used to transfer low close-out period products into the account of the higher close out period products if it were risk reducing to do so. This process would be similar to the early portfolio margining approach CME already offers e.g. eurodollar futures which offsets swaps risk can be moved from the futures account (1-day margin) to the swaps account (5-day margin).

    Unfortunately this approach would be a significant amount of re-education and infrastructure re-engineering for the market which is used to “futures / futures infrastructure 1-day, swaps / swaps infrastructure 5-day” simplistic assumption. However, with so much of the derivatives market economics at stake it feels like something like this will have to happen to resolve the conflict appropriately whilst being able to say the system is adequately robust.

    always be speeded up whilst market liquidity (the real comparable factor driving the margin model) doesn’t change. dwelling exclusively on the close out period to the point of ignoring other factors in the models (confidence intervals, historical scenarios set chosen (if used)) may be over-simplistic.

    Comment by flintspark — February 4, 2013 @ 8:32 am

  7. You realize that when folks are talking about whether or not margin cover was sufficient (CME, LCH, or anywhere else) they’re talking about a single random pull from a distribution. Drawing conclusions (whether or not margins were set appropriately) off a sample size of one is…debatable, to put it nicely.

    Comment by CF — February 4, 2013 @ 2:22 pm

  8. Can anyone explain to me how a “swap future” differs from at traditional exchange-traded futures contract?

    Comment by Rob — March 29, 2013 @ 11:35 am

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