If Congress really had its way (well, Democrats anyway) all swaps would look and trade like futures. And if your days involve trading or processing either, you already know that this situation presents a classic square peg/round hole problem.
Case in point: Eurex launched iTraxx futures in 2006 and no liquidity ever developed. But times have changed, and although I'm not completely convinced the world needs credit-default-swap (CDS) futures, the upside if the contracts are successful is big enough that it is nearly inevitable that these products will come to market ahead of CDS trading and clearing mandates later in 2012. Why?
To begin with, clearinghouse margin requirements for CDSs are considered by many market pros as unnecessarily high. Complications related to clearing sovereign and bank CDSs — two of the most highly used CDS segments — will leave margin requirements for those products even higher than for index CDSs. These high-margin requirements alone could open the door for CDS futures, as the margin requirements for futures are tracking much lower than for comparable swaps.
Second, credit is a pretty fascinating market these days. I wouldn't go so far as to say it's a good market, given all of the turmoil and volatility; but for those whose investment strategies rely on turmoil and volatility, new instruments that make it easier to bet on the creditworthiness of a company or country could draw serious demand.
Futures contracts would allow smaller players investing smaller amounts of money into the space. The average CDS trade is roughly $10 million in notional value. Futures contracts would likely bring that down to $1 million or less. And since only initial margin would be required to open the position, one could take a CDS-like position for between $50,000 and $100,000. Not exactly an appropriate investment for your mom's 401(k), but certainly good for small hedge funds and professional investors.
Success Is No Guarantee
Despite these upside drivers for CDS futures, success is anything but guaranteed. Over the past few weeks the topic of CDS futures has come up more frequently in conversations with industry participants. In fact, we discussed this backstage at Tabb Group's recent Fixed Income Trading 2012 event in New York in January. Everyone agreed that several firms are "working on the problem."
A Tabb Group report estimated that 80 percent of CDX.IG trading in the interdealer market is happening electronically based on a highly standard contract. Remember the Big Bang in 2009? That activity begs the question: With such a standard and relatively liquid market already in place, why do we even need futures? It's really nothing more than a different regulatory rubber stamp calling the product one thing over another.