Rate swap traders wait for no man

By Michael Mackenzie


US regulators still have to finish writing the rules that will shape the new world of derivatives trading. The highly competitive US interest rate swap markets, however, are not waiting.

In Chicago and across the Atlantic, clear signs of the future for US swaps trading are emerging. This new environment looks set to be populated by a wide range of competitors offering both voice and electronic dealing.

In August, Icap, the inter-dealer brokerage, unveiled an electronic platform for trading euro denominated interest rate derivatives. Cantor Fitzgerald's BGC Partners has started a similar platform. These are seen as laying the ground for an eventual assault on the US market.

Gary Gensler, chairman of the Commodity Futures Trading Commission, believes more than 40 new swap trading platforms known as swap execution facilities, or SEFs, will emerge in coming months.

It remains for the regulators to define exactly what is meant by the broad description of SEFs as outlined in the recently passed Dodd Frank financial reform act. SEFs will be required to permit multiple parties to trade and also publish streaming prices. This criterion meets the desire of regulators for a more transparent and open market and moves over-the-counter derivatives trading towards a futures type model.

In this shake-up, inter-dealer brokers are hoping to capitalise on their dominant positions in swaps markets. Nonetheless, they are not the only ones looking to the future. Alternative swap trading venues, electronic exchanges for derivatives deals, are gaining traction.

Newedge, a futures broker, recently announced it had transacted $2bn of interest rate swaps on the Eris exchange, based in Chicago. This exchange was launched by high frequency trading firms, such as Getco and DRW Trading, in July.

"Swap clearing and trading market structure is evolving rapidly even though final regulations are months away," says Richard Repetto, principal at Sandler O'Neill & Partners. "For interest rate swaps, the market appears to be changing quickly, even without regulatory action," he adds

These moves come as the Commodity Futures Trading Commission and Securities Exchange Commission work on preliminary rules for trading swaps in SEFs with proposals due for public comment in December.

The precise structures of SEFs, therefore, remain unknown. But the combined use of voice and electronic systems under a hybrid model is seen as being a key feature of SEFs, placing the inter-dealer brokers in a prime position as they already act as de-facto SEFs using a combination of screens and voice brokers.

"A good portion of the swaps market activity is dealer to dealer, and the inter-dealer brokers handle the majority of that volume," says Kevin McPartland, a senior analyst at Tabb Group.

For banks, the move to SEFs means that they will likely no longer be able to market swap prices directly to their clients via their own Bloomberg screens. Instead, the banks will direct their prices to third party SEFs that transact swaps between dealers and the buyside community of hedge funds, money managers and corporations.

These third parties include Tradeweb, which is owned by a consortium of dealers and Thomson Reuters, and planned platforms at Bloomberg and MarketAxess. Javelin Capital Markets, backed by some dealers, is also seeking to set up an electronic trading system.

Such trading activity will still need a healthy interbank swaps market for banks to offset their client trades. The move by Icap and BGC Partners to start electronic systems in Europe, leaves them potentially in the box seat with dealers in the US, some argue.

"We suspect that ICAP and BGC Partners could begin trading dollar swaps without much incremental effort," says Mr Repetto.

Frits Vogels, managing director for interest rates at Icap, believes SEFs will boost trading volume and points out how the euro swap platform recently transacted 18 trades between eight banks simultaneously, something that would be impossible to accomplish under voice broking.

He said after the first month of trading, the electronic order book had already captured 17 per cent of Icap's euro interest rate swap trades, with the value of trades exceeding 50bn ($69bn).