Feb 13, 2013

The Futurization of Swaps – Dissecting the Debate

In this video blog, James Jockle, Numerix CMO, and Udi Sela, 20-year FX veteran and Vice President of Client Solutions summarize the current debate and market viewpoints resulting from the Commodity Futures Trading Commission’s  recent roundtable on the “Futurization of Swaps.” Our guest outlines the key stakeholders driving this debate and the position each player has taken.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section below.

Jim Jockle (Host): Hi and welcome to Numerix Video Blog, I’m your host Jim Jockle. Debate is something we always think about in terms of Washington D.C. and the ability to cross the aisle is something that is the backbone of American politics especially around the election year, but there’s another debate going on, specifically as relates to derivatives and the futurization of swaps. One of the key players are not two parties but actually four: the regulators themselves the CFTC, the exchanges, swaps dealers as well as the commodity players you can even throw in the hedgers if you will so let’s round that table of debate out to five. With me today to talk about this is Vice President in the Client Solutions Group, Udi Sela of Numerix. Udi welcome.  

Udi Sela (Guest): Thank you, good morning Jim. Good to see you.

Jockle: Good to see you too Udi. Udi, why don’t you take us from a high level and start walking us through the debate and the positions of each of these players as it’s been quite an interesting discourse over the last few weeks.   

Sela: Sure so we really need to understand what is behind each player and well try to touch on that. So, we start with the regulators. So obviously the main objective is to regulate the market to make sure the crash we experienced in 2008 will not happen again and tax payers will not have to bail out institutions anymore. That is the regulators.

Then we have the exchanges. So let’s have a look at the economic context. Over the last year or so, trading volumes have declined. And if you look at the overall share of exchanges in the derivatives business we’re looking at something between 10 perhaps and 15 percent so the interest of the exchanges of course is to capture more business. So trading derivatives over exchanges of course will give both trading and clearing revenues. That will be the exchanges.

Then we have players that are looking to build SEFs, swap execution facilities, and we also need to understand that swap is a very broad definition so it’s not just swaps, swaps will be probably be the container for many other similar derivatives. So people who have invested over the last few years into training facilities to have clearing and regulating swaps. So obviously they want to see return on these investments.

And then the next player is the OTC players, the typical Goldman Sachs of this world, or even larger buy-side firms like BlackRock and so forth. And they of course have an interest of the seeing business thriving within the OTC space because this is how they make their profits.

And then we have to look at the commodity players, which probably most of them are comfortable with trading futures within exchanges because they get the prices transparency and there’s no pricing discrimination and we can touch on that later.

And the last player to think of is the hedgers. So think for instance about an airline, in need to mitigate energy costs like fuel. So typically these guys’ trade commodity swaps which are pretty complex, very much customized, tailor made if you like. And they most likely need the flexibility of the OTC market because moving into hedging by exchanges would mean increasing the trading volumes much heavily because we need to understand that swaps are hedged using strips of futures so that would mean that if I need to mitigate an exposure for the coming year or two years, I would need to trade a large amount of futures. So that’s that in a nutshell.

Jockle: So one of the overarching goals that I think thematically we’ve heard many times is leveling the playing field. So between the swaps and futures markets ensuring consistency, transparency, consistent margins, however, not everyone agrees in terms that the approach that’s being taken is actually leveling the playing field and introduces concepts of regulatory arbitrage. What are some of your thoughts on that?

Udi: So I’m actually happy you asked this question because I wanted to allude to that, what happens today is that in terms of how many days of margin one needs to put aside, the playground is not level in my opinion. So if you look at futures, typically you have to set aside one day of margin, if you look at SEFs, you’re looking at five days, and of course if you’re looking at uncleared swaps it can be twice or if you’d like ten times over, futures. So that means, people who’ve invested into SEFs, are now in an inferior position as oppose to trading in exchanges because the cost is much more comprehensive, and the thing is, that basically what will happen is to drain capital, like we take this airline that we mentioned earlier, if you take working capital out of the daily business into margining, it’s an open question, do we really want to do that especially in this economic climate?

Jockle: So I want to focus on the question of cost. One of the estimates of common terms of clearing swaps can cost almost five times more than futures. Can you expand on that just a little bit more, I know you touched on that just for a second? 

Udi: Yes, looking from the side it does look weird and indeed the cost over SEFs will be five times over. If you listen to people like Gary Gensler from the CFTC, he’s said that it is only natural to expect some changes in the industry landscape given the new regulation. But of course if you are a vendor or financial institution that has decided to invest in building a SEF, obviously you will feel uncomfortable and you will feel the cost structure will push players to trade over, what we call the futurization of swaps because it will be much cheaper.

And I would think, it would make sense, to see if most derivatives are representing the same risk, it would make sense to have similar margining requirements. So perhaps one has to look, instead of asking for one day margin, perhaps one has to ask for more.

Jockle: One final question, and this is something that is near and dear to the Numerix audience, which is around the concepts of hedging, because risk managing is something that every Numerix user is thinking about now, futures inherently are not necessary a good solution as relates to hedging, due to lack of flexibility, can you expand on requirements and what in a futurized world could that look like, and some of the risks that are not met by utilizing futures for hedging.

Udi: Okay so again, we can take the example of an airline, we can look in the same manner of a mining company; just for the sake of it we’re looking at aluminum.  And I need to hedge my receivables in the coming two years, because typically people hedge in the commodity space, hedge at least year out. Now if you look at liquidity, typically liquidity in futures is reserved to the front months, so it’s very difficult, if I need to hedge a complete cash flow over let’s say 12-24 months, I would need to trade a large amount of futures.

Now, in most futures I will not have liquidity, so that means I would have to build a hedging scheme/program, I will not be able to build that in one shot, and then I would have to trade spreads to buy front months, sell the end months etc., at the same time when I’m looking at the swap, let’s say on a monthly basis, a one year swap is monthly fixings, I can get a lot of of flexibility, I can get my hedging in one shot, and I can align five different banks to look for the best price. So from a hedger’s perspective it is much more convenient to trade using swaps, and why not clear it over a SEF.

Jockle: Udi thank you so much for your time today, much appreciated. Clearly this is going to be a debate we’re going to be watching as we go forward as the rules are getting finalized and everybody understands what the level of playing field actually will look like.  We want to hear from you. Please follow along on twitter @nxanalytics as well as on our blog. Any feedback, we’ll be happy to hear from you and get involved in the debate as well. That will do it for today, I’m Jim Jockle and thank you Udi Sela for your time and we’ll see you next time. Thank you.

Udi: Thank you Jim good bye.

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