This is a very good article covering issues with swap futurization. The term refers to Dodd-Frank regulations (abetted by Basle III) requiring that derivative contracts formerly made through dealers must, in the future, trade through exchange-like venues and be cleared so as to lessen their risk of default.  The concern being expressed is that customization features may be lost as these OTC contracts are replaced by standardized contracts.  Among these features are tweaks that address convexity problems that arise from futures contracts being marked to market.  ERIS Exchange has been very innovative in this effort.

A year or so ago I was pushing another approach.  It is widely understood that an interest-rate swap can be replicated with a bundle of eurodollar futures at various expiries.  My approach was to enable a user to define the needed swap contract as if working with a dealer but on submission the “swap” would be broken down into the futures contracts that would replicate the swap.  Essentially, a “swap” would become an order type with the dealer being replaced by software.  Customization features such as needed for convexity problems as well as caps and floors would be handled through the software.  Because all the pieces would be executed through a futures exchange, the Dodd-Frank requirements would be met via markets with well-established liquidity and clearing arrangements.

My presentations provoked two concerns.  The first was execution risk.  Since the pieces of the “swap” order may not be executed immediately, there is execution risk.  My response to that was that I would expect the initial order flow to be limited to short-term vanilla contracts.  From that start I would expect entry of market making facilities would improve liquidity to the point where the necessary contract tweaks would obtain sufficient immediacy.  I do not buy the argument that all end users require immediacy all the time.  The cost savings from bypassing OTC dealers would mitigate the emphasis on immediacy for some end users.

The second concern seemed to weigh more heavily.  The exchanges I talked with were concerned that they would be competing with the existing dealer community. My response was to predict that they would find themselves competing with dealers in any case.  Sooner than I expected but that is precisely what futurization is doing.