CME Swaps on Swapstream Efficient and Effective
CME Swaps on Swapstream will be welcomed by interest rate market participants looking for a better way to trade.
What happens when you combine the benefits of a centrally cleared product with attributes of an over-the-counter (OTC) product? The interest rate world is about to find out when, later this year, CME Swaps on Swapstream (CME Cleared Swaps) will begin trading, offering the OTC interest rate market the first-ever, centrally cleared interest rate swap available to all market participants. CME Cleared Swaps will offer the efficiencies and financial safeguards of a futures contract, while maintaining much of the flexibility of an interest rate swap. The product will be centrally cleared using CME Group's OTC clearing solution, CME Clearing360. Trades can be submitted for clearing either through Swapsteam's sPro platform or using CME Group's web-based Front-End Clearing system.
The OTC interest rate swap market is a significant market internationally. According to the International Swaps and Derivatives Association (ISDA), the notional principal outstanding for all interest rate swaps was $382 trillion by the end of 2007, after converting swaps from all currencies into dollar equivalents. Of this total, U.S. dollar and euro-denominated "plain vanilla" swaps comprise the lion's share of the market.
Conventional interest rate swaps involve the exchange of cash flows - one based on a floating interest rate, the other based on a fixed interest rate - indexed to a notional principal amount. These exchanges usually occur at three-month or six-month intervals. Typically, the floating rates are three-month or six-month London Interbank Offered Rate (LIBOR), and fixed rate is the rate at which the market value of the two cash flows are equal at the time the agreement is entered into.
CME Cleared Swaps are true interest rate swaps, not a futures contract on an interest rate swap. While they standardize certain terms of the agreement, they maintain flexibility and trading structure comparable to vanilla interest rate swaps.
Maturities follow OTC market protocols. The maturity of U.S. dollar-denominated CME Cleared Swaps can be between three months and 30 years, so long as it is measured in three-month increments. Similarly, a euro swap can be between six months and 30 years, so long as maturity is measured in six-month increments. The cash flows for U.S. dollar CME Cleared Swaps are quarterly and fall on the International Monetary Market (IMM) Wednesday of every third month following the forward start date of the swap. For euro swaps, cash flows are twice a year and fall on the IMM Wednesday of every sixth month following the forward start date of the swap. The swap size can be any size the two counterparties agree on, so long as the notional amount is a multiple of 100,000 currency units, whether dollars or euros.
The key differentiator between vanilla interest rate swaps and the new swap product, and what generates major benefits to both counterparties, is the presence of CME Clearing in the transaction. Once the two parties reach agreement on the terms of the swap, the clearing house becomes - as it does with futures and options on futures - the buyer to every seller and seller to every buyer, virtually eliminating counterparty risk. In today's market, concerns about counterparty risk have never been greater and are not limited to any one asset class.
"The recent credit crisis has emphasized how important it is to control our exposure and manage collateral and counterparty risk," says Diego Magia, principal of the Elcano RV Fund. "CME Swaps on Swapstream will help us benefit from all the efficiencies of a clearing house without sacrificing the way we conduct our OTC business."
In addition to mitigating counterparty risk, the presence of CME Clearing in the equation eliminates the need for ISDA master agreements or any of the other cumbersome OTC transaction documentation. Until now, ISDA documentation has presented a hurdle to many market participants.
John M. Huber, chief investment officer of Voyageur Asset Management, says, "The costly and laborious process of getting ISDA agreements for our customers...has kept us from trading swaps in the past. CME Swaps on Swapstream removes these obstacles."
Positions are marked to market daily, providing an additional level of financial safeguards and offsetting positions are automatically netted. In comparison, OTC positions are not netted, which creates balance sheet inefficiencies.
Eventually, CME Cleared Swaps will trade electronically on Swapstream's sPro platform. Transactions will then benefit from the sPro platform's straight-through processing. Swapstream Chief Executive Officer Stephane Rio believes that the straight-through process from order to clearing will attract interest rate swap traders to the product.
"Straight-through processing means that when a user clicks to accept the deal, the system automatically transmits it to clearing," Rio says. "With no ticket to write, no trade entry to make, and no order confirmation to send, the Swapstream system eliminates these potential sources of error."
The fact that 33 buy-side firms in the United States and Europe are participating in an early adopter program for these swaps provides an obvious measure of the value market participants see in joining OTC swaps with exchange-style clearing. The list of program participants includes banks, mortgage lenders, asset managers, hedge funds, and proprietary trading firms. Among them are such well-known names as Julius Baer Group, Capula Investment Management, Citadel Investment Group, Commerzbank Group Treasury and Henderson Global Investors.
Kai Franzmeyer, head of Commerzbank Group Treasury, likes the price discovery aspect of electronic trading. "Electronic trading with multiple market makers leads to tighter bid-ask spreads and greater price efficiency," Franzmeyer says. "Also, with the prices right there on the screen, you will avoid having to call all the dealers. For Group Treasury, with its many swap positions denominated in billions, this is an important gain in efficiency."
To this, Swapstream's Rio adds, "Asset managers often need to be able to show proof of best execution. Electronic trading proves it. It's all there on the screen."
Underscoring the importance of being able to access the swap market efficiently, Franzmeyer adds, "Whether we want to hedge our own or other bonds, swaps are the best hedge for what we do in Europe. They are far more effective than, say, bond futures. This ultimately will be a very efficient way to do our swap business."
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