Intercontinental Exchange and Eris Innovations are revamping the pricing structure of their European interest rate swap futures to make the contracts more user-friendly. A similar change has already proved highly successful in the U.S., and the two companies are now working to roll out the new pricing structure in the third quarter.
The new approach was announced on March 13 when the two companies extended their licensing agreement. Eris Innovations designed the contract to replicate the cash flows and the economics of an over-the-counter interest rate swap, and ICE Futures Europe has listed euro-denominated and pound sterling denominated interest rate swap futures based on this design since June 2015.
The key change is in how the contracts are priced. Starting in the third quarter, the ICE contracts will be quoted and traded in futures price terms instead of net present value. In practical terms, that means the contracts will be quoted as 100 plus the net present value of future cash flows, plus accumulated past cash flows, minus accumulated price alignment interest (PAI). PAI represents the overnight interest paid on collateral, the standard practice with collateralized OTC interest rate swaps but not traditional interest rate futures. In addition, the direction of the contract will be switched so that a long position in the new swap future will imply a receive fixed/pay floating swap position, rather than the other way around.
Michael Riddle, chief executive officer at Eris Innovations, said the "futurization" of the pricing format is partially the result of the firm's experience in the U.S. market. When Eris decided to migrate its U.S. dollar-denominated contracts to CME's Globex platform, Eris also made a similar change in its pricing methodology from net present value to futures price terms.
That migration took place in December, and since then trading activity has exploded. Volume rose from around 2,000 contracts per day in 2018 before the switch to about 5,200 contracts per day on average in the first three months of 2019. March is shaping up to be a record, with more than 9,000 contracts changing hands per day on average.
The primary reason for the jump in trading activity was the listing on Globex, which greatly increased the number of intermediaries and end-users with access to the swap futures. Globex is one of the most heavily used electronic trading platforms in the futures industry, and virtually every major clearing firm and technology provider is connected to the platform. But Riddle said the change in the pricing structure had a meaningful impact on the operational requirements and made the contracts more appealing to futures market participants. For example, the USD interest rate swap futures now are more easily supported on investment management solutions such as those offered by Charles River Development, and thus easier to integrate into trading operations and risk management as a "vanilla new product" without extra layers of development or support, he said.
"In opening up the U.S. dollar contract to a larger distribution by going up on CME, we also coupled that with changing the pricing quotation format instead of pricing in net present value. That adapted the contract from having conventions that looked more like a swap to something that looked more familiar to futures users," Riddle said. "We radically increased the distribution of the U.S. dollar contract not just by getting it out on CME Globex, but also helping it fit with futures more cleanly in the front-office, middle-office and back-office."
Eris Innovations is now looking to apply the same approach in Europe with its partner ICE Futures Europe. "We want to take the lessons learned from that success, and apply it to the Euro and sterling contracts," Riddle said.
Geoffrey Sharp, managing director and head of sales at Eris Innovations, added that the products are also proving their value to more and more market participants. The recent surge in trading activity for the USD futures has been driven by market participants who are shifting their risk positions into the swap futures. Because the contracts are cleared as futures, they are subject to lower capital requirements than cleared swaps, and they also benefit from margin offsets against other interest rate futures cleared at CME.
"There has also been a sweep-up into Eris from other risk products, because there's tremendous value to an end-user who has directional risk and wants a lower capital footprint and a simpler, more liquid instrument to use," Sharp said.
The two Eris Innovations executives said that in the coming months they will be collaborating with ICE Futures Europe to introduce the new contracts to clearing firms, technology vendors and trading desks
"Over the last 10 years, the futures and the swaps markets have started to converge, and firms are looking for increasingly automated and efficient ways to trade and standardize risk," Riddle said, adding that the evolution of Eris pricing methodology reflects this trend.