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Morgan Stanley (MS - Analyst Report) announced its plans of making an equity investment in Eris Exchange – a U.S. futures exchange that offers Interest Rate Swap Futures. Morgan Stanley is the latest addition to the list of financial institutions making increased investments in derivatives ahead of an expected surge in standardized derivatives trading.

The financial details of the transaction were not disclosed; however, it is expected that Morgan Stanley will acquire a minority stake in Eris early next year. The company will also join the board of directors of latter as part of the deal.

Under the provisions of the Dodd-Frank Law, nearly $639 trillion worth of over-the-counter derivatives will be moved to exchanges and routed through central clearinghouses. This will make swap trading more regulated like futures trading, thereby mitigating the risks associated with over-the-counter swap trading largely.

The reforms are likely to generate massive interest in futures as well as the newly-formed hybridized derivative instruments – better referred as swap futures. According to a survey by Morgan Stanley, a large section of investors is more than willing to increase their trading in so-called swap futures.

Consequently, big financial institutions that are eager to move away from traditional OTC derivatives trading have found very good opportunity in the swap futures. This has resulted in heightened competition in the swap futures trading space.

Close on the heels of Morgan Stanley’s announcement of stake buyout,  Intercontinental Exchange Inc.(ICE - Analyst Report) agreed to acquire NYSE Euronext for cash and stock worth $8.2 billion. The merger underscores the growing importance of derivatives trading going forward. Moreover, Chicago-based CME Group Inc. (CME - Analyst Report) introduced an interest-rate swap futures contract, which is traded on the exchange, but delivers an off-exchange derivative at expiry.

We believe that the stake buyout in Eris Exchange would prove lucrative to Morgan Stanley in the future. With the conventional OTC derivatives trading set for a major overhaul, amidst the stringent regulatory landscape, swap futures will provide investors other profitable investment avenues.

Currently, Morgan Stanley retains its Zacks #3 Rank, which translates into a short-term Hold rating. Considering the fundamentals, we also maintain a long term ‘Neutral’ recommendation on the shares.

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