April 9, 2013 7:22 pm

Swap traders’ morning fix under scrutiny

Icap©Bloomberg

For two decades, one electronic page on trading terminals has dominated the shadowy world of interest rate swap trading between banks and their clients.

Known as 19901, its legacy page number from the defunct Telerate era, it retains a crucial role in the $164tn US swap dollar market, which is now attracting regulatory scrutiny.

The going rate

The going rate
The growing size of the OTC derivatives markets

Every day before 11am in New York, 16 banks provide the rates at which they would buy and sell a benchmark swap. The rates are collated to provide the ISDAfix, named for the International Swaps and Derivatives Association.

For the past decade, ICAP, the largest interdealer broker, has published the page, using the prices supplied by banks that transact swaps. That means traders are keen to do business with ICAP because they want the screen to reflect their trades.

So lucrative is the business for ICAP that its brokers call its rate-swaps desk in Jersey City by a more catchy sobriquet: “Treasure Island.”

Now some of those brokers at ICAP and traders among the 16 global banks that submit rates have been subpoenaed by the Commodity Futures Trading Commission as it investigates claims of possible market manipulation.

Both ISDA and ICAP said they were co-operating with the CFTC. ISDA added that has hired Oliver Wyman to help advise on what modifications it needs to make to its oversight of the fixing process for swap rates. The banks declined to comment.

This world of tight relationships between dealers and their brokers is coming under intense pressure after regulators uncovered abuse in the setting of a different interest rate gauge: the key global floating rate benchmark known as the London interbank offered rate, or Libor.

Investigation by international regulators has produced large fines and management upheaval at banks starting with Barclays. Other institutions are expected to settle with regulators in the coming months.

But the ISDAfix probe shows that regulators’ concern extends well beyond Libor into crucial if obscure benchmarks. It will also shine a light on interest rate swaps, a crucial area of the derivatives market that plays a key role in helping companies and investors protect themselves against sudden changes in interest rates.

ISDA has previously described the ISDAfix as a “transparent, readily available value to which parties to a transaction can refer as a settlement rate”.

Even as the CFTC was sending subpoenas to market participants last November, the trade association wrote to the European Commission to argue for the benefits of its benchmark. “Without such a benchmark, it might be necessary to go through the process of calling a number of active dealers for quotes in order to settle transactions,” ISDA wrote.

After it hired Oliver Wyman to review the process on Tuesday, Steven Kennedy, head of strategy and communications at ISDA, said: “We understand that best practices have emerged via the Wheatley Report and we want to make sure that the ISDAfix is in accord with those practices.”

The Wheatley Report was produced last year by Martin Wheatley, now chief executive of the new Market Conduct Authority in the UK. His was the main UK government-ordered report into lessons learnt from the Libor scandal. But it also identified explicitly ISDAfix as an area of concern.

Dennis Kelleher, president at Better Markets, says the Libor-rigging scandal shows that banks are willing to manipulate benchmark interest rates given the billions of dollars at stake. “It is laughable how – in the computer-driven 21st century – that the securities industry is still using old technology,” he says.

ISDA began the 11am fix in 1998 as market participants, seeking to unwind old swap trades or settle an option contract for a swap about to expire, sought a fixing rate that all could agree to follow. The methodology adopted for the fix was based on the Libor-setting process, subsequently revealed to have been rigged by some banks across a range of currencies.

The ISDAfix formalised the custom of dealers supplying swap rates for an 11am fixing in New York each trading day, with ICAP reaping the benefit to the chagrin of its rivals.

While swap rates tend to track underlying Treasury yields, they can fluctuate independently of government bonds. This is very noticeable when companies sell debt and want to swap their fixed payments for a lower floating rate via the swap market.

The nature of swap trading means a small difference in pricing does matter given the large notional size of trades that can start at $100m and rise to $1bn and more between banks and their clients. In this world, a hundredth of a percentage point matters. A difference of a quarter or half a tick in a fixing is very important. For example, for a $100m 10-year swap trade, each basis point change amounts to a plus or gain of about $93,000.

In depth

Libor scandal

Analysis BIG PAGE Libor pfeatures

Regulators across the globe probe alleged manipulation by US and European banks of the London interbank offered rate and other key benchmark lending rates

Given the stakes and the highly competitive ego-driven world of traders, there has long been talk in the market that some of the larger banks seek to influence swap rates ahead of customer deals. Often, ahead of the fixing, swap prices can fluctuate sharply, with a trade from a bank required to change the mid-level of the swap before 11am.

ISDA and ICAP established trading protocols for the fixing process and have insisted the process used to calculate the ISDAfix was fair and beyond reproach. But the concern is that banks may have got around those guidelines in the same way they circumvented the Libor process.

In a statement, ICAP said: “It maintains policies that prohibit any of the behaviour that has been alleged in the media.”

The probe also raises questions over the role of brokers in setting rates and encourages the acceleration of rate-setting based on computerised trading and transparent prices from the broader market.

“I can’t see how 19901 can exist – they will have to change how it works,” says a broker.

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