Swap to the Future (the futurisation of swaps)

I read an interesting article recently about the hesitancy of US swap markets to move towards a ‘futurised’ model. It got me thinking: given the pressure from regulators for the industry to move in that direction, what’s the hold up?

Now, this is a gross over-simplification, but for anyone unfamiliar with the market, I’d think of an OTC swap as a tailored suit – generally more expensive to purchase, but cut to your dimensions (at least if you go to a good tailor). Meanwhile, a future is more like one you buy off-the-peg – typically less expensive, but cut to standard sizes and perhaps not an exact fit.

Unfortunately, that’s as far as the analogy goes, because the risk of buying an ill-fitting suit is trivial (particularly if you’re like me and not too bothered by appearances). You might end up with something a bit too baggy, or more likely in my case, sleeves and trousers that are a bit too short. But at the end of the day, the worst that can happen is you offend someone’s fashion sensibilities.

By contrast, the financial instrument you choose to hedge your exposure really does have to fit. The risk that your chosen hedge doesn’t match your exposures is known as ‘basis risk’. And that risk is by no means trivial.

Take the example of Aracruz Cellolose – a Brazilian producer of pulp and paper (it’s an example close to my heart as I was born in neighbouring Vitória while my father worked for the firm in the seventies). As one of the world’s largest pulp exporters, Aracruz had significant exposure to currency risk. The price it received for its product was denominated in foreign currency. So when the Brazilian Real strengthened, its domestic earnings would suffer (earning fewer Reais for each unit of foreign currency). To hedge this exposure, the company took positions in the currency markets. While the Real appreciated, Aracruz made a financial gain on its hedge, off-setting the negative currency impact on its core business. Happy days. The problem came when the Real devalued rapidly. Rather than simply off-setting currency gains from its core business, its ‘hedge’ resulted in a huge trading loss – more than $2 billion – the seventh biggest in history according to Wikipedia, and almost enough to bankrupt the company.

Now, if I was a corporate treasurer looking to hedge my company’s currency or interest rate risk, my ability to enter into a bespoke contract that precisely offset my cashflow exposures is something I may pay extra for. Encouraging me to move towards standardised products and accept a certain amount of basis risk in return for cheaper transaction costs wouldn’t be an easy proposition to sell.

That said, as with all risks, good data and analytics can help mitigate the problem. Perhaps there are ways of minimising basis risk by stitching together off-the-shelf products to better match one’s exposures (the equivalent of buying an off-the-peg suit and having it adjusted). Conversely, just because something has been hand tailored doesn’t guarantee it will be a good fit.

High quality data and analytics can help price all risks; not just the basis risk of your chosen hedge being a poor fit. But when new markets are being born – historical data is not available straight away. So even if you can accurately model the theoretical value of a contract, you do not know how technical factors will behave – what bid/offer spreads will be like, what happens to prices when liquidity is squeezed etc.

Given the stakes involved, it is perhaps not surprising that markets are taking their time in swapping to futures. In fact, the thought of one market being a perfect substitute for another is itself an over-simplification. Just like most people buy suits off-the-peg for everyday use, they may still be tempted to have them tailored for special occasions.