The Intercontinental Exchange (ICE) is set to launch hybrid credit default swap futures for the second time on April 27, after its June 2013 attempt failed to gain traction.
The launch is geared towards cashing in on an expected move of traders away from over-the-counter markets as Dodd-Frank regulations make the products more costly.
Market participants believe traders will embrace hybrid futures that are more standardised but less costly than their OTC counterparts.
ICE successfully converted its energy swaps contracts into futures in 2012 for the same reasons, and a wide swathe of exchanges and trading platforms have moved to launch hybrid interest rate swap futures to attract trader activity in rates markets.
Credit poses a different problem though, as the constituents of such benchmarks as the Markit CDX North American Investment Grade or High-Yield indices – which two of ICE’s contracts will reference – often deteriorate in credit quality, forcing Markit as index provider to substitute weaker credits for stronger ones on a rolling basis.
That wrinkle makes it difficult to list a future that references the index, since constituents can change every several months. ICE launched its first hybrid future under a “when-issued” format to address the problem – the contract predicted what the next index constituents would be based on index rules. But the uncertainty of not knowing for certain whether those predictions were correct led traders to avoid the product.
“The uncertainty cost of the ‘when-issued’ feature seems to [have] exceed[ed] the futurisation ‘benefits’ (reduced burden from registration and reporting requirements), putting an end to the CDX swap futures,” Or Schachar, economist in the Federal Reserve Bank of New York’s Research and Statistics Group, wrote in a note on the subject.
This time ICE has licensed methodology created by Eris Exchange that embeds the cash flow and economics of an analogous OTC product into a cash-settled futures contract through variation margin payments, allowing the contract to reference on-the-run indices.
“The introduction of an on-the-run contract is in response to market feedback and provides a capital and operationally efficient way to trade CDS exposure that will be accessible by a broader market segment,” said Krishan Singh, president of ICE Swap Trade.
ICE’s upcoming credit futures will reference the iTraxx five-year Main and Crossover benchmarks – along with the five-year North American IG and HY yield indices.
Dealer support
On a client call on Thursday, participants asked ICE how it planned to win the support of the dealer community, who help new products get off the ground by providing liquidity but are perceived to support OTC markets over futures, due to the higher fees that OTC products often earn.
“There is a growing understanding amongst credit participants that we need to increase the pool of participation in the credit space,” said Singh.
“This is a great launching board to do that as it provides non-traditional participants the ability to get similar exposure to OTC markets that they would not normally be able to access.”
The exchange also expects margin offsets with the platform’s Russell and MSCI product suite to incentivise product use, Singh said, adding that it has created ‘liquidity provider’ and ‘market-maker’ incentive programmes to further entice participants into the product.
ICE plans to launch interest rate swap futures denominated in euro and sterling based on the Eris design in the second half of this year.