Swap futures are set to head north of the border as Chicago-based swap futures venue Eris Exchange has agreed to license Eris Methodology, its proprietary product design and intellectual property (IP), to Montréal Exchange, the Canadian derivatives exchange arm of TMX Group. And the hybrid product could soon venture still further afield.
Eris' patent-pending methodology replicates the economics of interest-rate swaps (IRS) by efficiently combining the component cash flows of swaps into a single futures price, allowing payments to flow through variation margin. Neal Brady, Eris Exchange CEO, tells Buy-Side Technology that Canada was a natural place to extend swap futures' footprint.
"We’re excited about this partnership with Montréal Exchange (MX), given that it’s our first expansion beyond the USD IRS market," Brady says. "The idea for an Eris Canadian dollar (CAD) IRS futures contract was initially driven by strong interest we heard from asset managers, insurance companies, hedge funds, and banks, many of which are already actively trading our USD IRS product. We’ve known the leadership team at MX for some time, and we worked closely with them over the past several months to structure the licensing arrangement."
The Canadian market—which doesn't have native over-the-counter (OTC) clearing capabilities for swaps, and instead has historically relied predominantly upon LCH.Clearnet and, to a lesser extent, CME—evaluated how to best design a product and technical infrastructure for offering CAD rate swap risk in the new mandatory clearing environment. According to Brady, three options were in play.
"The first is the traditional voice-traded or swap execution facility-traded OTC swap approach, involving posting swap margin with CME or LCH, or another OTC clearing service," he explains. "The second way is to utilize a deliverable swap future, which CME Group, Eurex and others are offering. This product can either be rolled quarterly as a future or, if taken to delivery, it exposes clients and market-makers to an OTC swap with a different margining, tax, and regulatory framework.
"Finally, there is the Eris product design and methodology, a contract that is cash settled daily and can be held as a futures contract all the way to maturity," the CEO continues. "Although the Eris quarterly contracts can be rolled like a traditional future, there is no forced roll or delivery into an OTC swap. All of the cash flows and collateral costs of a vanilla swap are captured in the Eris product design allowing for the contract to trade in an anonymous, central limit order book (CLOB) just like traditional futures, with execution on a variety of front-ends, efficient futures margins, margin offsets, and time tested post-trade processing."
In pulling in Eris to pursue the third option—instead of a multi-year internal buildout, or licensing the deliverable swap future IP from Goldman Sachs—MX and its exchange-traded instrument clearing subsidiary, the Canadian Derivatives Clearing Corp. (CDCC), reflects broader industry sentiment about the challenges facing the swaps market, and the opportunity alternative venues are likewise seeing to expand their reach.
"Our roadmap has always been to gain traction with the US dollar rates product and then expand our offering internationally and into other asset classes," Brady says. "The cost of OTC clearing is growing, causing banks to conclude that the business is not sustainable at current pricing levels. Similarly, buy-side firms are now posting margin against growing outstanding positions, and these capital considerations are now starting to directly affect trading and hedging decisions and traders’ choice of products and execution venues. Capital constraints, specifically supplemental leverage ratios (SLRs) for dealer banks, are driving the overall swap market toward standardization and compression of outstanding gross notional positions. As a result, there is a whole lot more interest these days in standardized swap futures."
To that end, Brady suggests similar licensing and partnerships will soon be forthcoming as Eris continues to leverage the work—both technical and educational—it has done to introduce swap futures to the industry.
"We're expanding the diversity of clients trading our USD IRS product while simultaneously expanding to other geographies," he says. "We’ve been very public about our intention to launch a European IRS contract in 2015 and our existing client based has made that a priority for us. Asia will come next, and at the same time, Eris will push beyond rate futures into other asset classes utilizing the same product methodology."
- The swap futures product design, using existing futures complex infrastructure and proprietary methodology, continues to grab hold in the market as MX will use Eris Exchange's intellectual property to develop an offering for Canadian dollar interest rate swaps.
- Eris says MX was a natural partner for its first foray outside the US, and is now eyeing further expansion with a European IRS contract likely to be introduced in 2015.
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