Cleared SWAPs – Where is product innovation in financial services going to come from? A panel of bank and independent hedge fund and market maker experts agree that cleared derivatives have become a logical path to the future, but the question is: when will it happen? Despite what participants recognized as advantages, there still has yet to be a “liquidity pop” in cleared versus non-cleared SWAP derivatives, JPMorgan’s Nick Rustad noted at the 32nd Annual FIA Futures and Options Expo.
Regulations are making non-cleared SWAPs capital iinefficient
Non-cleared derivatives rules and the capital inefficiency that has been created are “starting to bite” Citi’s Chris Perkins said. He believes the next wave of financial product innovation is going to come in terms of optimizing capital efficiency.
Cleared SWAPs – part of a “futurization” trend in the wake of the 2008 financial crisis – offer capital efficiency benefits. This plays into a key market trend towards overall efficiency, Nicolas Lenoir, a portfolio manager at PSP investments, noted. He pointed to increased regulations of non-cleared SWAPs as a factor that is making using such bespoke financial products less attractive.
Perkin’s notes a troubling “liquidity drain” that needs to be managed. Rustad said it is not only entering SWAPs trades that is important to consider, but also unwinding the trades where product innovation might be found.
Double standard when considering these SWAPs as adoption resistance weighs heavy
Don Wilson of DRW Trading, an innovator in the algorithmic market making space who has created cleared SWAPs products for a number of exchanges including Eurex, agrees that cleared SWAPs have benefits, but points to adoption resistance.
While he notes the trend towards these SWAPs is in the “final stages,” there is a sense of frustration that institutional investors have not migrated from non-cleared bank derivatives to the exchange traded model. “What will it take?” he rhetorically questioned. He noted that cleared SWAPs are capital efficient and perform a vital public price discovery function, but they have not been wholly embraced.
He says market participants need to “do the math” on these SWAPs, noting an odd standard used when considering the two products. “Investors complain that a cleared SWAP product might have 100,000 contracts of open interest, saying ‘that’s too small for me to trade because I would be too large a percentage of the market.’ But non-cleared SWAPs offer zero open interest,” Wilson said, noting a double standard that doesn’t get much attention.
“Why isn’t this discussed?”
When moving to cleared SWAPs, it is difficult not to note corollary in listed derivatives, where digitization that has cleared out human market making in listed derivatives will take over in non-cleared SWAPs. “It’s something people fear,” Lenior said.
The flexibility benefit to a custom contract is currently cited as a reason that institutional investors have not fully migrated, but Wilson noted that cleared SWAPs offer similar benefits.