Swaps clearing could boost Treasuries, futures markets

US Treasuries and futures may be the largest beneficiaries from reforms that will make the cost of transacting in the $364 trillion, privately traded interest rate swap market significantly more expensive.
If new rules, which are still being formed and are expected to be implemented next year, lead investors away from swaps and into bonds or futures, it may also dramatically impact the Treasury yield curve and could add to volatility in futures trading.
The rules are part of the Dodd-Frank law and are designed to reduce the systemic risks posed by the web of privately traded derivatives, which helped roil the financial system in the crisis of 2008.
The most extensive change will be the requirement that a majority of swaps be routed though central clearinghouses.
"This will represent a major shift in the behaviour of investors who have up till now enjoyed the fluidity of the swaps market," said Jim Caron, global head of interest rate strategy at Morgan Stanley in New York.
The rules "will push marginal transactions toward the cash and futures markets," he said.
Treasuries may benefit from increased demand from investors who need the bonds to pledge as collateral against swaps.
This is because most clearinghouses require participants post collateral as cash, Treasuries or other similarly highly rated securities. Bank of America estimates that the move to clearinghouses could require $600 billion in collateral, though much of this need could be met by securities already held by investors.
Others may decide that futures are more attractive because of the higher costs of entering into privately traded swaps. Morgan Stanley estimates that the cost of using swaps may be three-to-five times greater than exchange traded futures after the changes.
Many fund managers use swaps to manage the interest rate risk of their bond portfolios, and some said they might move some positions if swaps become too costly.
"To the extent there is an economic disincentive there we'll clearly look for other markets to get duration," said Robert Bayston, a portfolio manager at Standish Mellon in Boston, which manages $80 billion in assets. Bret Barker, a portfolio manager at Los Angeles-based TCW Group, which manages $120 billion in assets, agrees.
"If we had to choose, yields were the same, and we had to post more collateral, we'd probably go with the one that cost us less use of collateral," he said.
TCW has been a large user of interest rate swaps in the past but is currently not active, as it doesn't find them attractive at current valuations, Barker said. The firm expects to trade swaps again in the future, cost permitting.
Swaps liquidity will also be important in determining whether people shift out of the market, and this may depend on how large users like government-sponsored enterprises and banks react.
"From our perspective, the final concern is that if there turns out to be such an economic disincentive to use swaps that it starts materially affecting the liquidity of that market," said Standish Mellon's Bayston. "That is a concern to us as a user of the product."
Some see accounting advantages that GSEs and banks receive from using swaps as likely to keep them active in the market.
How pension funds and insurance companies react to the new regulations, meanwhile, may also have a large impact of the long-end of the Treasury yield curve, according to Morgan Stanley.