Since the People's Bank of China promoted the centralized clearing of the Renminbi interest rate swap market in 2014, market liquidity and trading convenience have been significantly improved, and professional investment institutions such as hedge funds have brought new considerations of leverage, liquidity and volatility to the market. With the optimization and upgrade of the "swap link" function, including the introduction of IMM contracts and contract compression functions, market participants can now more accurately manage interest rate risk, enjoy strategy diversity, and further promote the maturity and opening-up of China's financial market.

Centralized clearing has greatly improved the liquidity of the swap market.

In January 2014, the People's Bank of China's Notice Concerning the Establishment of a Centralized Clearing Mechanism for OTC Financial Derivative Products and Matters Related to RMB Interest Rate Swap Clearing Business (银发〔2014〕No. 29) clearly stated: "As of July 1, 2014, for RMB interest rate swap transactions newly reached between financial institutions with a reference to FR007, Shibor_ON and Shibor_3M, and with a term of 5 years or less (including 5 years), those whose participating entities and contract elements meet the relevant regulations of the Shanghai Clearing House shall be submitted to the Shanghai Clearing House for centralized clearing." The centralized clearing process includes but is not limited to: element matching, clearing confirmation, calculation of clearing participants' claims and debts, sending settlement instructions, and completion of claims and debts, risk management and survival management.

This provision has significantly improved the liquidity and trading convenience of the RMB interest rate swap market. As a central counterparty, the Shanghai Clearing House completely avoids the two core risks of the OTC market participants, namely counterparty risks and settlement risks. At the same time, the credit management of centralized clearing is replaced by the Shanghai Clearing House for unified credit instead of one-to-one bilateral credit. Since then, the participation of hedge funds, private equity products and the diversity of market participants have enriched the RMB interest rate swap market, which was led by banks, insurers, securities firms and funds.

(Alfred Tao, Head of Interest Rate Trading at Chorui Assets)

Interest rate swaps: the derivative products that are more suitable for professional institutional investors.

For hedge funds and other market participants, leverage ratio, liquidity and volatility are the main factors to consider when selecting investment targets, and funding costs are another key factor that is easily overlooked in the leverage ratio. Hedge funds have been labeled as "hot money" by the market, because capital naturally pursues high returns, and hedge funds are more sensitive to funding costs and implied time value. Credit lending and pledging repo are the two major financing channels in the interbank market, but these financing channels are not convenient for hedge funds, and often require higher funding costs. The product design of interest rate swaps just perfectly solves this problem.

The underlying connection of an interest rate swap is based on the 7-day repurchase rate and inter-bank lending rate, which in most cases hedge funds cannot directly obtain through interbank financing channels. The floating end of an interest rate swap ingeniously integrates these two major financing rates into the product design, so that hedge funds can directly obtain interest rates to obtain leverage. This financing convenience is not available in treasury futures, which are also interest rate derivatives.

Following the financing cost, the leverage ratio is inevitably involved. Exchange-traded treasury futures are favored and concerned by trend traders because of their highest leverage ratio, while the leverage ratio of interest rate swaps in the interbank market is no less inferior to that of treasury futures.

The Shanghai Clearing House will set margin ratios or corresponding leverage ratios for participants' interest rate swap portfolios based on the VaR values of all interest rate swap contracts' future cash flows, which is closer to the way fixed income practitioners measure and manage risks using duration or DV01 than the definition of margin ratio based solely on a fixed percentage of the contract value in treasury futures. In general, for hedge funds and other participants in the interbank market, setting margin ratios or leverage ratios based on duration or DV01 is a closer reflection of their actual risk management needs.

Usually, market makers provide liquidity mainly to participating institutions in the interbank market, but the interbank market is a highly rational market dominated by institutional investors, and does not have the long tail effect of the exchange market, often resulting in convergence of trading or unbalanced liquidity.

Unlike financial institutions in the inter-bank market whose trading needs are mainly hedging, hedge funds have a more flexible trading method in the interest rate swap market. It is not difficult to find in international markets that such participants provide a lot of liquidity support to the market.

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Hedge funds mostly use bilateral arbitrage for trading, which can provide stable long-short trading demand in any market environment. This mitigates the market-making pressure and liquidity exhaustion problems of one-sided market makers to a large extent. From a trading perspective, assets with good liquidity can be traded on a large scale quickly and inexpensively. The improvement in market liquidity requires participants in this type of asset to have real bilateral trading demand.

Domestic banks mainly participate in the interest rate swap market, so the liquidity and trading volume of this market are much higher than the government bond futures market. It is not enough for only market makers to provide liquidity for such a large market. It is precisely because hedge funds have a higher risk appetite and will have transaction demands that are different from other financial institutions under extreme market conditions. It is necessary to encourage more such participants who have actual trading needs to enter this market and increase liquidity depth and breadth.

Currently, the issuance of ultra-long-term bonds tends to become routine, and for institutions that cannot participate in government bond futures in the interbank market, the active period of interest rate swaps is only up to 5 years, which cannot meet the demand for rational term hedging. The most active tenors in the government bond futures market are ten and thirty years. We have seen that the volatility of 30-year government bonds has indeed risen significantly, which has a higher impact on valuation. Market participants, especially those who need to allocate assets, need more effective tools to correspond to corresponding market risks. Considering that the issuance of 10-year government bonds has the largest volume in the country, the interest rate swap market requires a longer active period, especially for 10 years. This has a more concrete positive feedback effect on the full pricing of the primary and secondary markets of 10-year government bonds. In addition, compared with the benchmark interest rate curve of general developed economies, the interest rate curve of US dollar intersections, with overnight repurchase rate as the target and SOFR OIS, can have a trading period of up to 50 years, and most developed economies have benchmark interest rate curves based on 10 years.

Interest rate swaps important milestone: the transition from spot-to-IMM contracts.

For equity and commodity markets, volatility is the main source of capital gains, while the certainty of coupon interest naturally generated by fixed-income assets makes allocation-type institutions averse to net price volatility, especially because the noise volatility generated by excessive and irrational speculation by market participants. All participants in the interest rate swap market are professional investment institutions, and the entry threshold is relatively high, often more rational than the government bond futures market variety. The main strategy of hedge funds participating in the interest rate swap market is relative value, and some of these carry trade strategies contain the characteristic of shorting volatility. Therefore, these participants often prefer interest rate swaps, which are relatively rational and fully priced and stable markets.

Currently, most of the domestic interbank interest rate swap contracts start with spot interest rates. For participating financial institutions, the most direct management pain point they face is the difficulty of offsetting interest rate swap contracts after the start of the interest accrual period, resulting in a large accumulation of outstanding interest rate swap contracts on the books.

In addition, banks, insurance companies, and securities firms mostly use interest rate swaps as hedging tools, and using spot-starting contracts as hedging tools has problems such as duration-ladder decay and implicit riding hedging costs. As an important milestone in the process of opening up China's financial market to the outside world, on the first anniversary of the launch of the northbound "Interconnection", Shanghai Clearing House, China Foreign Exchange Trading Center and Hong Kong Off-Site Calculation Co., Ltd. optimized and upgraded the "Interconnection" function, added IMM contracts and historical start Interest contracts, and support contract compression and other functions.

From the experience of the international market, the outstanding amount of IMM contracts is much larger than that of spot-start bonds. These optimized new functions perfectly solve the three major pain points of the spot-start interest rate swap contract mentioned above, especially the IMM contract that pays in international currency settlement days, which standardizes spot interest rate swap contracts and makes it easier to trade and compress standardized contracts. It helps market participants to more accurately manage interest rate risks and provides more diversity of strategies.

Chorui Asset's interest rate derivative trading team has started to use international currency settlement day IMM as the starting day to trade forward-starting interest rate swap contracts with several mainstream market-making brokers in the domestic market since 2023. This optimization and upgrading of the Interconnection makes us feel full of motivation and look forward to the RMB interest rate swap market. As a participant in hedge funds, we also hope to provide more liquidity for the RMB interest rate swap market, and call for more domestic and foreign managers to participate in this standardized interest rate swap market together and make progress together to promote the high-quality development of the RMB interest rate market.

(Special author: Alfred Tao, Head of Interest Rate Trading, Chorui Asset)