September 16, 2013 10:00 pm
The financial reforms triggered by the financial crisis are starting to make their presence felt in the $300tn privately negotiated US derivatives market.
With the counterparty risk of swap transactions now being assumed by centralised clearing houses, the focus of the industry is on how the trading of swaps will develop.
A number of firms are formalising new transaction venues known as swap execution facilities, and these “Sefs” will compete with established futures exchanges to enable trading between banks and institutional investors. The development is seen as opening up an industry long dominated by big global derivative banks to greater competition, resulting in lower trading costs for investors.
The new swap trading era pits a host of players in open competition against each other, from the well-established interdealer brokers such as ICAP, to big platforms run by Bloomberg, Tradeweb and MarketAxess, to a number of new entrants such as State Street and Javelin.
The leading derivative exchanges, namely CME Group and the IntercontinentalExchange (ICE), and other vendors are seeking to entice users of over-the-counter (OTC) swaps towards futures contracts that are cheaper to clear centrally.
As Wall Street has lobbied hard to water down financial reform, an undercurrent among players in the established swaps industry has been the fear that exchanges such as CME and ICE would emerge as the big winners from a wholesale evolution of OTC swaps from a telephone-based market to computers.
“Either OTC swaps or swap futures could be the winner,” says Charley Cooper, head of exchange-traded derivatives at State Street Global Exchange, which has filed a Sef application, and also provides technology support for the Eris Exchange and its swap futures contract.
“In our discussions with clients we heard a preference for OTC swaps and swap futures, so we are offering them both, so we can capitalise on the way it plays out,” says Mr Cooper.
According to Richard Repetto, principal at Sandler O’Neill Partners, leading executives at the CME believe it is not yet clear how far the OTC market will shift towards futures, while the presence of dealers remains important.
“The CME believes the dealers will continue to play a significant role in the trading and clearing of IRS [interest rate swaps], at least in the near term,” says Mr Repetto. “On a five-year forward view, CME believes it is still unclear how much of the OTC will stay cleared and remain OTC or convert to a futures-like product.”
Chris Edmonds, president of ICE Clear Credit says their credit index futures contract, launched in May, was developed in response to demand from investors who may not generally participate in the OTC market. “This is a credit product that appeals to non-traditional players, looking to hedge macro credit risk.”
Mr Edmonds says ICE is looking at launching a full suite of credit-related products that would complement existing OTC products in the future.
As the world between dealers and investors converges, all prospective swap trading platforms will need to connect with a wide range of participants. For interdealer brokers, this means moving beyond talking to a limited number of banks. Existing platforms such as Bloomberg, TradeWeb and MarketAxess that already link banks with institutional investors are expected to hit the ground running once Sefs are fully operational.
Many of the new trading venues will not only offer streaming prices that enable users to buy or sell a swap on a screen with the click of a computer mouse, they are also going to provide a request for quote (RFQ) service, whereby an investor can seek a price from a limited number of banks or other market makers.
“The winners will be those platforms that listen to their customers and give them a choice of ways to transact,” says James Cawley, chief executive officer at Javelin Capital Markets, which has filed to become a Sef. “In a commoditised market place, it is the relationship that wins.”
The use of RFQ is seen as helping banks to preserve their market share, but if more investors gravitate towards an anonymous electronic trading book, it is seen as shifting the market to an exchange model.
Chris Ferreri, a managing director at ICAP North America says while it is too soon to tell whether the OTC market will move towards a futures-type model, the cost of trading is a key factor for users of derivatives. “If the cost to clear and margin a future is less than a swap, then it’s more of a challenge for clients to transact swaps and not futures,” he says.
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