Banks flinch as derivatives head back to the future

WASHINGTON Mon Dec 10, 2012 11:37am IST

Stocks

   

WASHINGTON (Reuters) - The latest challenge to investment banks' iron grip on finance has its unlikely roots in agriculture.

Since the mid-1980s, Wall Street has built a $650 trillion playground for speculators using financial instruments called swaps. These were originally designed to insure companies against financial risks.

Now, investors are shifting away from swaps into similar contracts called futures, which farmers have used for centuries to protect the value of their crops and livestock from sudden drops in market price].

Both futures and swaps contracts are bets on anything from interest rates to foreign exchange levels or commodity prices. Technically, they are different, but economically they can function in much the same way.

Swaps, dominated by investment banks and long unregulated, risk becoming more expensive to use than futures now that watchdogs are clamping down on the former, blamed by critics for exacerbating the 2008 financial crisis.

Philip Obazee, the head of swaps and futures trading at asset manager Delaware Investments, has been weighing up the merits of the two different types of derivative.

He looks favorably at last week's launch of a new product by the CME Group Inc (CME.O), the world's largest futures exchange, which promises clients the same characteristics as swaps at a far lower cost.

"I am watching it very carefully," he said, speaking on the telephone from a Philadelphia trading floor.

"Am I going to use it? Definitely. Am I using it on day one or two? No. I want to see how the market develops."

If futures start replacing swaps in earnest, it would be a salient example of how the U.S. Dodd-Frank overhaul of Wall Street - and similar efforts in Europe and Asia - are starting to reshape the competitive landscape.

Investment banks such as JP Morgan (JPM.N), Citi (C.N) and Bank of America (BAC.N) would see one of their most lucrative products hurt, while futures exchanges gain.

Officials from these three banks were not immediately available for comment.

The biggest threat is for the more standardized types of swaps, which are easiest to replace by futures. Bankers say there will always be the need from customers for more complex swaps, which rarely trade and have a high value.

TARGETED ATTACK

Futures have a venerable history. Trading was big enough in 1531 for the Flemish city of Antwerp to build an exchange for early forms of the contract. London and Amsterdam followed suit in 1571 and 1611 respectively.

The CME's precursors have been trading such contracts since around 1850, and the practice soon became regulated. The market is now overseen by the Commodity Futures Trading Commission (CFTC) - the top U.S. derivatives regulator.

The Dodd-Frank overhaul of Wall Street gave the CFTC massive new powers to regulate swaps trading, which takes place out of sight from regulators, mostly in bilateral contacts between buyers and sellers over the phone.

New rules will bring most swap trading onto exchange-like platforms, with clearing houses standing between buyers and sellers to shield against default. Trading data will become public in central repositories.

The CME's new product - called swap futures - is a targeted attack to lure clients because they worry about the impact of all those new rules, in particular the costly need for higher safety margins in swaps as opposed to futures.

"These contracts require half the margin of cleared interest rate swaps," said Sean Tully, CME's global head of interest rate products. "We're trying to provide the most efficient solution for the market under the new regulations."

Another futures platform, Eris Exchange, has launched a similar product, while the Intercontinental Exchange (ICE.N) is replacing certain types of swaps with futures contracts. All cite the new rules as the reason.

The stakes for the banks are high. They provide no insight into how profitable swaps trading is. The units that include the business are large revenue drivers.

"In interest rate swaps, the core suppliers of liquidity have been the major banks. Therefore, they dictated the (cost of the swap for the user) between themselves," said one industry participant, asking not to be identified.

"If that goes across to futures markets, they could be challenged by the larger funds (asset managers). The banks are reluctant to watch this happen," he said.

BANKS FIGHT BACK

Defenders of swaps say that they provide more flexibility. For instance, a capital goods manufacturer with an order book stretching decades ahead would struggle to hedge all its currency and interest rate risk by using futures.

"Futures are like (what) Henry Ford said about the model-T, you can get any color you want as long as it is black," said Craig Pirrong, a professor of finance at the University of Houston who has published about derivatives.

Moreover, accounting rules stand in the way of using futures for those companies who need to accurately match their hedges with the value of assets to avoid losses.

And because of exemptions, there is less of an advantage into moving over to futures for risk hedgers than for financial investors, the large funds who invest in derivatives purely for speculation purposes.

Still, hedgers - or end-users - make up only 10 percent of the market. If the big financial speculators moved into futures, the swaps industry would be under serious threat.

A Risk magazine survey of 10 big asset managers who invest in derivatives - including BlackRock, Alliance Bernstein, Eaton Vance (EV.N) and Vanguard - found in October that all these firms are considering shifting into futures.

Already, investment banks are positioning to fight back if that happens: Citi (C.N), Credit Suisse (CSGN.VX), Goldman Sachs (GS.N) and Morgan Stanley (MS.N) will function as market makers in the CME's new product.

Moreover, many large investment banks are among the world's top futures brokers. But the sore point is that futures are a lot less profitable than swaps, in part because futures have a greater pricing transparency.

And while futures may be a crude tool now, providers will make sure that customers will get more choice later.

"It is possible, if not even probable, that the futures world will make steady progress against making their products more and more customizable," said Luke Zubrod at Chatham Financial, a consultancy firm.

If he is right, more speculators will start using futures. And that can only mean bad news for banks.

"If the liquidity ... does start to go into futures market, then yes, the margin pressure for standardized swaps will be immense," the industry participant said.

(Reporting by Douwe Miedema; editing by Andrew Hay)

Comments (0)
This discussion is now closed. We welcome comments on our articles for a limited period after their publication.

  • Most Popular
  • Most Shared

REUTERS SHOWCASE

Canada Shooting

Canada Shooting

Attack on parliament, killing of soldier stun Canada's capital.  Full Article 

Earnings Season

Earnings Season

Wipro sees rosier end to year as U.S. clients spend.  Full Article 

Business Climate

Business Climate

Fears for tough penalties grow as India cleans up business  Full Article 

New Email Service

New Email Service

Google launches new email service dubbed "Inbox".  Full Article 

DLF Appeals

DLF Appeals

DLF seeks interim relief from capital market ban  Full Article 

Falling Oil Prices

Falling Oil Prices

Indian consumers respond to softer oil, food prices  Full Article 

Book Keeping

Book Keeping

RBI fires warning shots on companies' lack of FX hedging.  Full Article 

Policy Repo Rate

Policy Repo Rate

Most external members suggested rate cut in RBI's Sept review.  Full Article 

Reuters India Mobile

Reuters India Mobile

Get the latest news on the go. Visit Reuters India on your mobile device.  Full Coverage