Neal Brady has spent the last five months or so working to get the Eris Exchange up and running as the first swaps futures exchange created after Congress passed the Dodd-Frank financial reform bill ordering swap trades onto public exchanges. As the deadline looms on finalizing Dodd-Frank, Eris aims to be the venue of choice for clearing services to reduce systemic risk in the over-the-counter market. Thus far, the new exchange for interest rate swap futures has handled over $19 billion in notional value since trading started in August.
Q: How did you get involved with the Eris Exchange?
A: I was previously managing director and head of business development globally for the CME. While I was at CME I was very involved in a variety of initiatives related to OTC clearing and trading. After leaving CME to run a venture fund where I was involved with many of the Eris founding partner firms, we began discussing with CME the possibility of clearing an interest rate swap futures product as a way to broaden access to the OTC interest rate swap market and respond to the new regulatory environment. I’ve been in the exchange and derivatives business for a long time and founded a venture several years back called Liquidity Direct which was eventually acquired by the CME. A number of proprietary trading firms were involved in that earlier venture as well as founders and partners, and that’s how I ended up being involved with Eris.
At Eris Exchange, we’re up and running with a product and clearing solution that is very much within the spirit and guidelines of the Dodd-Frank legislation. There is a lot of talk in the marketplace about what new cleared OTC products and platforms will look like a year or two from now. What distinguishes Eris is that we are operational today with a product that meets the Dodd-Frank guidelines for OTC clearing and trading while using the tried and true infrastructure of the futures markets and not forcing firms to cut over to new and untested ways of doing business and processing derivatives trades. Eris also opens up access to a market that hasn’t traditionally been open to all. To trade in this market, it has traditionally required bilateral arrangements, ISDAs, lengthy OTC documentation procedures, and a willingness for each dealer to admit each customer, one by one, as an acceptable counterparty. At Eris, we have created a product that directly replicates – dollar for dollar – an OTC interest rate swap product, but it is cleared and so available to a much wider community – anyone with a clearing relationship with an FCM who also qualifies as an Eligible Contract Participant as defined by the CFTC.
The Eris swap futures contract is very flexible – you can trade at any coupon rate you’d like and at any maturity day out to 30 years. If you have a valid customer account with a futures commission merchant at the CME that has more than $50 million in capital, you’re eligible to participate. So it’s an open access model that replicates the OTC market. We are also applying to the CFTC to become a designated contract market (DCM), at which point the Eris contracts will sit in 4d accounts at the FCM. A 4d is the account class that traditional futures accounts sit in – so Eurodollar futures, Treasury Futures, etc. all sit in 4d accounts. Once we become a DCM, our contracts will sit in that same pool and then will be eligible for cross-margining at CME against Eurodollar and Treasury futures. That will be a big capital savings for users of our product and we’re very excited about it. Once that’s available, there will be an even more significant cost advantage and capital efficiency advantage to using our product. We expect to become approved as a DCM this year.
Last but not least, we are also promoters of increased transparency in the market, so we announced a technology partnership with State Street Bank who is providing a matching and trading platform for us. When we launch on the State Street platform early this year, you will see liquid quotes for 2-, 3-, 5-,7- and 10-year benchmark maturities in interest rate swaps– two-sided, transactable streamed quotes from dedicated liquidity providers– the founding partner firms plus others that have signed up to stream quotes as well. This liquidity will be available to any customer or front end provider that is connected to State Street’s global trading platform. We’re very excited about offering that to buy side users and others interested in accessing the market.
Q: So this is strictly swaps? You have no interest in trying to compete with, say, the CME Group on Treasury products?
A: No, we have no interest in that. We are here to tackle the OTC-cleared market with a unique futures product. We think the CME’s core business is their core business and they are very good at what they do. CME is purely a clearing services partner for Eris and they have an open clearing facility. They are not an equity owner in the exchange. We are an independent exchange, but cleared through the CME, and we’re very happy to have them as our clearing partner.
Q: Who do you see as your main customers at the Eris Exchange?
A: The main customers are anybody who today is an interest rate swap user – asset managers, corporates, hedge funds, insurance companies, GSEs like Freddie Mac and Fannie Mae – anybody who is a participant in this market that wants to lay off or put on a position at the Eris Exchange. There is also a lot of interest from emerging dealer banks that don’t have the same ISDAs and bi-lateral arrangements that the top tier dealers have. We are targeting anybody who trades interest rate swaps today. Many of these participants will be required to do all their business – cleared – on the date that Dodd-Frank becomes effective. If Dodd-Frank becomes effective a year from last July, at that date many firms will no longer be able to trade bilateral standardized swaps; they will need to do them cleared, either on a DCM or on a SEF. There are a number of emerging SEFs, but we aim to be the benchmark interest rate futures venue that also fulfills the Dodd-Frank mandate. Lastly, we also think there are non-traditional users, who currently do not have access to these markets, who will come into the market once it is a cleared marketplace. These are the users who don’t have the time, resources or back office expertise to set up ISDAs and bilateral arrangements with the dealer banks.
Q: Could you tell me a little bit more about these new users?
A: We think there are banks and a variety of other users that would like to participate in the interest rate swap market but don’t because it’s too much of an operational burden to set up proper bi-lateral arrangements. In terms of market-making, there is a large community that would more actively make prices upon request or stream transactable prices if they had access to this market. These firms are not making markets today because they don’t have access. Once you provide clearing, the issue simply becomes who can reliably provide the most competitive prices and significant size.
Q: It seems there is an awful lot happening right now in terms of OTC and swaps. Who would you see as your main competition? Do you have a first-in advantage?
A: We think it will be a very interesting couple of years as the industry migrates to cleared interest rate swap trading. There are a number of swap execution facilities (SEFs) that are in the early stages of being formed, and that are only waiting for the specific rules from the regulators on what it means to be a SEF and details on required trading platform protocols. Right now the CFTC has put out proposed rules for public comment and the market is waiting for the official rules to be published and the time line for implementation. The CFTC has recently proposed rules to describe how to register as a SEF and there are a number of initiatives and corsortia discussing the possibility of forming SEFs. So certainly we think there will be a number of SEFs out there. I think anybody who has seen markets develop would probably assume that there will be some sort of consolidation and aggregation. There will be a number of SEFs and liquidity pools that consolidate down to a handful of primary venues. What we aim to be is the primary benchmark futures market equivalent that exists alongside the major SEF platforms.
It’s a very large market, and if we can get a meaningful percentage of that overall market we will definitely be considered a success. We think our futures product in all likelihood will be carried on a number of third-party front ends and put in front of major buy side firms — along with prices from various other SEFs. The legislation mandates that swaps need to trade either on a SEF or a DCM and we believe the clients should be free to decide which execution and clearing venue most suits their needs.
We also think our unique contract design distinguishes us from the rest of the market as it fully “futurizes” the economic exposures of a standard, cleared OTC interest rate swap. We do that by embedding all of the economics of the swap into a single futures price that gets independently marked-to-market and settled every day. Periodic cash flows are accrued and paid on a daily basis and get reflected in the futures price. We only move cash via the daily variation margin process that is well-known to the futures industry. Our product design is novel enough that we have even filed for a patent on some aspects of our final settlement calculation that allows us to truly match the economics of a standard OTC swap dollar-for-dollar.
We passed $18 billion in notional trading the other day – which relative to the overall OTC rates market is small, but we’ve shown that trades can occur and get seamlessly processed by futures back office infrastructure. Customers can use their existing futures systems and are not required to implement any new modules.
Q: Could you give any examples of the early interest in the Eris Exchange and its products? Examples of how enthusiastic the financial industry is about your services?
A: In every major client segment, we have interested participants that are actively pursuing or testing this out and working with us. We have a number of major FCMs that have processed trades, and many more in the pipeline getting ready. On the end user side, we’ve had interest from all the major participant types including asset managers, insurance companies, corporate, GSEs, hedge funds and major proprietary trading shops.
We are up and running and are available to almost the entire CME FCM population, so we are unique, and that draws a lot of interest. Every one of the major client groups is actively looking at how they are going to respond to and meet the coming regulatory requirements.
Q: How do you see the exchange evolving?
A: Our product road map involves moving from spot-starting, dollar-denominated interest rate swaps to forwards, which is a big part of the market, and then onto swaptions (options on forwards). That will require a lot of organizational focus from the exchange and support from our clearing and technology platform providers, and we’re very busy at the moment executing on that roll-out plan. Beyond that, we could eventually move into different asset classes and other non-dollar-denominated products.
Q: What would be a rough time line for these other products?
A: We are actively working on a number of product fronts with our various partners and will come to market as we have agreed upon time lines for launch. Dollar-denominated forwards is the next product in the queue for us to launch.
Q: Does the public, or at least the investing public, have a better handle on the OTC market and how the market works, or will the OTC market always be on the fringe to the educated retail user?
A: We are certainly targeting an institutional user base and not the retail market. Even if it is centrally cleared, an over-the-counter interest rate swap is a product tailored to the institutional user. However, after the recent financial crisis, the educated retail market and even the general public has become much more aware of the systemic risk and the pitfalls of bilateral, over-the-counter trading. The general investor and the general U.S. taxpayer is now aware of the risks inherent in OTC derivatives trading and the importance of assessing risk exposures daily and not letting losses accumulate. One of the major lessons we can all take away from AIG and the financial crisis is that futures-style margining works very well, and the system works because there is an independent risk assessment made and money moves daily based on the settlement prices determined by the independent clearing house. So even if the retail investor will not participate in institutional products on Eris Exchange, I think in the post-crisis environment an educated investor or even general taxpayer can appreciate the role this product fills in the marketplace.
Now, do I think OTC products will come into the mainstream? Potentially, for other asset classes, but I don’t think interest rate swaps will be a major area of growth in the near term for the retail market. Retail investors are much more involved in equities, metals, agricultural commodities and ETFs. Interest rate swap futures are a little more capital intensive and more of a customized product for institutional clients.
Q: Were you hoping to do something like you are doing now when you were in school?
A: I studied government and international economics in school, I got an MBA and a master’s in international affairs and I started my career at the IFC-World Bank (International Finance Corporation), so I worked heavily in emerging market finance.
I was based in the U.S., but traveled to Asia, Africa, Latin America. I did a lot of work around the world. Then I came back to Chicago, where I grew up, and worked at the CME in emerging market product development. I was involved in international market development and then worked at the CBOT in a similar area. At CBOT we provided international consulting to emerging market exchanges who wanted to set up their own derivatives exchanges.
I’ve been involved in markets and new market development from early on in my career, and then started Liquidity Direct, which was an options spread trading platform focused on the interest rate options market and supported by a number of major trading firms in the industry. After we were acquired by CME, I ended up running CME’s business development, working on things like CME’s investment in BMF in Brazil and a variety of OTC clearing initiatives.
So could I have predicted that I would be running an OTC interest rate swap futures exchange? No, that’s based on the particular moment in time and the specific macroeconomic context today. But I’ve been involved in starting new product ventures, new exchange-type ventures my whole career. That’s the logical progression. I moved from emerging markets to something more close to home, but it still involves opening up new markets and providing access to new products.
Q: Is there anything else that we haven’t talked about that people should know about the Eris Exchange or its products?
A: I think the message that we haven’t touched on is this is a very exciting time for the futures industry. The futures market performed extremely well during the recent financial crisis. It handled the Lehman default and bankruptcy without a hitch.
Whereas major players were having issues in the OTC market, the futures market was a stable source of liquidity throughout that crisis. I believe if the industry transition to cleared OTC trading occurs the way we envision, it will be a boon to the futures industry in general. This is a major shift in the futures markets and the capital markets in general, and it’s a whole new world of opportunity.
It will ultimately result in a much better, more stable product for the current OTC end users. They get transparency, they get independent marks, they get a more robust credit facility on the back end and they don’t have to worry about balance sheet exposure. They get all the benefits they currently have and they remove a significant part of the risk.
Overall, it’s a big win-win for everybody. And it will be a very interesting couple of years as this all plays out.