Hedging interest-rate risk used to be pretty simple: a company would issue debt and simultaneously enter into a custom-fit, over-the-counter interest-rate swap with a financial institution. But the Dodd-Frank Wall Street Reform and Consumer Protection Act put an end to that simplicity: Dodd-Frank requires most OTC-traded derivatives contracts to go through a clearinghouse — so all transactions are handled by a central counterparty.
The requirements haven’t taken effect yet, at least as they pertain to end-users of swaps, such as nonfinancial companies. But now, a large futures and options exchange is adding something else to the mix: futures contracts tied to interest-rate swaps that allow companies to lock in the terms of a swap for a future date.
CME Group, formerly the Chicago Mercantile Exchange, is launching “deliverable” interest-rate swap futures in early December. The instruments will have maturities of 2 years, 5 years, 10 years, and 30 years to start, as well as quarterly contracts. At maturity, the futures contract will convert into the underlying interest-rate swap of the selected tenor. Before maturity the holder could, of course, sell the contract or roll over its position.
“If you buy a July 2013, five-year LIBOR fixed-pay futures swap, you have effectively locked in a swap spread for that future date, and on that date you will have a swap at the clearinghouse,” says Richard Paulson, managing director in the banking and capital markets advisory group at PricewaterhouseCoopers.
Centrally cleared swaps and now futures products will provide nonfinancial companies more options for hedging interest-rate risk. And that’s a good thing, because, although bilateral OTC interest-rate swaps aren’t going away, they could get more expensive. If a corporation arranges a fixed-pay swap in connection with a floating-rate loan — a “commercial use” of swaps — that derivative would fit within Dodd-Frank’s end-user exemption and would not have to be centrally cleared.
Nor would the company necessarily have to post any collateral. But because banks and swap dealers will have a host of new regulations regarding OTC swaps, these bilateral products, even for nonfinancials, could definitely cost more.
Trading futures or entering a centrally cleared swap would require a company to post margin, of course. So companies will have to compare the costs. Swaps futures or centrally cleared swaps could be especially attractive to companies with low credit ratings, says Paulson.
When such companies enter into a bilateral swap, they might be asked by the bank to post collateral or provide credit support anyway, he says. The cleared product could actually have lower margin requirements in comparison.
The CME says cleared interest-rate swaps and swaps futures provide distinct advantages. A listed market is highly transparent, for one. But these products also eliminate bank counterparty credit risk and are much more liquid than an OTC derivative, says Sean Tully, global head of interest rates at CME Group.
“When a corporate does a trade with a single bank, it’s really a bespoke contract — not just on the date and the size, but on the two counterparties. So it’s completely dependent upon their creditworthiness,” says Tully. With a futures contract or a cleared swap, “you have a fungible instrument that you can get multiple parties to price if you ever want to exit the transaction.”
To “exit” a bilateral swap, in contrast, a company would have to either enter into a contract that offsets the original OTC instrument or try selling the swap back to the bank. Another choice — selling the swap to a third party — would require the original bank to accept the buyer as a counterparty.
“In general, terminating the swap creates difficulty, friction, and increased costs,” says Tully.
The flip side for corporations thinking of using futures: with a swap future, the end-user would have to post initial margin as well as “variation” margin: a payment based on an adverse price movement in the futures contract. In other words, the position has to be marked-to-market daily. “The company would need to manage the liquidity situation” surrounding the trade, says Tully.
Perhaps more important is the exposure to basis risk. With bilateral swaps, companies create something specifically tailored to their needs. But in a futures market, contracts are standardized, so the hedge and the underlying liability may be imperfectly correlated, creating the potential for excessive gains or losses from hedging. And there might not be a futures contract to match the desired time period for a hedge.
“The risk you will see in the interest-rate swap futures world will kind of mimic what you see in commodities, where some contracts just don’t exist; i.e., jet fuel or certain grades of commodities, so you hedge with whatever’s available,” says Gurpreet Banwait, a director of product management at derivatives risk-management and valuation company FINCAD.
In theory, using such an inexact hedge could disqualify a company from using hedge accounting, which requires a derivative be “highly effective,” its value moving in a near-perfect inverse relationship to the liability.
“Our clients in general have a hard time understanding how the swap they entered into hedges their risk with respect to hedge accounting,” says Banwait. “This just brings another level of expertise that would be required inside a treasury or accounting department.”
The final rules on swaps from the Commodities Futures Trading Commission and other regulators will be a key input to what is essentially a math problem for corporations, says Paulson: Will the cost advantages of the listed futures or cleared swap product outweigh the financial and operational costs that come with it, and how will those costs compare with the higher price of executing an OTC bilateral swap?
The sheer complexity of replicating a highly tailored bilateral swap with a listed product or products (a company may need to hedge currency risk with futures at the same time) may also scare off CFOs. “It’s more complex than simply settling your interest-rate swap coupon payment every quarter,” Paulson says.
Indeed, already available interest-rate swap futures from Eris Exchange that embed the cash flows of OTC interest-rate swaps into futures have captured only a fraction of the market.
Still, Paulson says the interest-rate swap future is an interesting product. “It’s the type of innovation we are expecting more of since the regulatory bias favors listed and exchange-traded products,” he says. “But the market will be the arbiter of whether this product takes off or not.”