Swap Trading Platform

James T. Moser (630) 386-1195 jtmoser.jr@gmail.com

James T. Moser August 2011

Dodd-Frank Requirements
Standardized swaps must be
SEF (Swaps Execution Facility) traded Cleared

Nonstandard and exempted swaps

Trade bilaterally Not required to clear

Swap positions recorded at SDR (Swaps Data Repository )

Swap Volumes
Report on Trading Derivatives (IOSCO Technical Committee, February 2011):
The International Swaps and Derivatives Association (ISDA) and others have stated that there are less than 2,000 standardised interest rate swaps executed globally on an average day. The most liquid swaps (10-year dollar interest rate swaps) trade about 200 times per day, while most swaps trade less than 20 times per day.

Multiple organizations interested in becoming SEFs

Implication
Aggregate trading volume too low to
Achieve liquid markets Obtain scale economies

Worse: volume split among several SEFs Predictions:

Swap contract market will be roiled SEFS fail Migration to non-regulated markets

My Approach: Re-Define Problem

Change problem FROM
Market design for trading intact swap contracts

TO
Design an order type for executing trades that establish swap-equivalent exposures

Example:
Three-year vanilla interest-rate swap for $120M Equivalent to 12 orders for 12 contracts ($1M notional each) expiring on successive settlement dates over next 3 years Total number of contracts: 144

Why Might Proposal Work?

Proposal matches what OTC dealers already do.
Dealers take fixed and variable sides of their customers positions Offset their net exposure in futures markets My proposal bypasses intermediary, the customer places an order to create a futures position that replicates the interest-rate exposure of a swap contract.

Margin for DCM positions expected to be lower than for SEF positions

Technical Aside: Replicating Payments

Define rt ,t k as the expected one-period interest rate in k periods, rt k as the realized one-period rate in k periods, and r as the fixed rate for a swap, then

the rate portion for settling a short forward contract is

t ,t k

rt k

and swap settlements for a fixed rate payer are

rt k r

Technical Aside--continued
Equivalence of a swap with a strip of forward contracts implies that r is the present-value weighted average of the

rt ,t k

and deviations of rt k from r for the fixed rate payer and the rt ,t k for a short forward strip will be well correlated. Hence, a swap paying fixed and receiving floating (variable) can be approximated by a strip of short futures contracts and a swap paying floating (variable) and receiving fixed can be approximated by a strip of long futures contracts.

Further Reasons Proposal Can Succeed

Swap contract market will be roiled
Swap users will be looking for alternatives Rather than rely on what has worked in the past Pushed to consider new approaches

20 years of MBA training established a cadre of mid-level managers who understand swap-futures equivalence
Unlike now, when swaps established derivatives expertise was scarce Dealers provided needed advisory and execution services Advisory services less needed today for standardized products Automating execution services can shift a sizable portion of swap business to an order-submission platform for futures

What Will It Take?

An intuitive and useful interface for end users
Intuitive Useful
Provide expected order execution price Provide margin required to carry position Provide expected order-completion time Possible: condition order entry on liquidity parameters Possible: what if modeling

A contract parser to restate swap contracts as bids and offers for

Futures Options on futures

Connect interface to clearing system to determine collateral needs Make parser an order entry route into electronic order book Sizable marketing effort

Additional Needs
Parser will need correct for convexity Legal, tax and accounting issues:
Is proposed facility a SEF or DCM? Meet FASB 133 hedge requirements? Tax considerations?

Potential needs
At start up compensation for market making services Encourage use of algorithmic trading in options trading Specialized membership category

Potential Benefits
Trading volume
Market Potential
2,000 contracts daily (IOSCO Technical Committee) Assume average contract is $120M notional, 3-year tenor, 4 settlement dates per year Implies daily volume of 288,000 contracts

Eliminate need for dealer in standardized swaps

All swap trades add to futures volume rather than only dealers net swap positions Lower cost for standardized swaps lessens attractiveness of bespoke contracts

Ability to offer greater liquidity in back-month futures and option contracts attracts participants