Meet the new OTC market-makers

New swap trading platforms are often seen as a way of levering open the OTC market for a range of non-dealer market-makers – from opportunistic buy-side firms to aggressive Chicago prop shops. But how many of these firms are serious, and what difference will they make? Joe Rennison reports

It’s one of the great unknowns of derivatives market reform: will non-dealer firms use the new regime, with its all-to-all electronic trading platforms, to take on the banks that have enjoyed a decades-long stranglehold on swap market-making? 

Risk has spoken to nine firms – including hedge funds and asset managers, high-frequency traders and proprietary trading shops – that want a piece of the over-the-counter market’s $693 trillion pie (see box, Indications of interest). Most insist on anonymity, with some claiming dealers have warned them away. But a few are willing to speak about their ambitions publicly.

“We would all like to trade,” says Chris Hehmeyer, chief executive of HTG Capital Partners in Chicago, which is a member of the 29-strong principal traders group (PTG), run by the Futures Industry Association. “We think we are capable – HTG and others like us, such as the firms in the PTG. Most of the firms are in wait-and-see mode, and that’s where we are too. But we are very interested.”

Tower Research Capital says much the same. The New York-based high-frequency trading firm – also a PTG member – is currently best known as an equity markets player, but Risk revealed on February 1 that it is involved in a new rates trading venture with Credit Suisse. 

“Tower is definitely supportive of swap trading moving toward open, efficient electronic trading. And we think, over time as these markets mature, we will be participating as both liquidity providers and price takers,” says Marc Vesecky, the firm’s chief risk officer. 

We would all like to trade. We think we are capable – HTG and others like us, such as the firms in the PTG

The most assertive comments to date have come from KCG – the entity formed when Chicago-based Getco acquired Knight Capital following the latter’s automated trading blow-up in 2012. “As our chief executive pointed out in our earnings call at the end of January, we have intentions to be trading interest rate swaps by the end of the year,” says Isaac Chang, global head of fixed-income derivatives with KCG Holdings in New York, and a former US head of electronic trading for rates products at Goldman Sachs.

The aim for the prop shops is to be in the market continuously, providing a bid and an offer at any given point in time, and capturing a small spread with each trade. Buy-side firms have a different goal – in line with their fiduciary responsibilities they will quote if they feel they can improve on the prices otherwise available. “Absolutely. We have a deep desire to be able to access these markets. We have the ability already. Legally and operationally we are able to do it. There is nothing that stops us doing it. Are we doing it now? No. We will only show up when we want to. We will not be in the order book 24/7,” says Sam Priyadarshi, head of fixed-income derivatives at Vanguard Asset Management.

That is echoed by Michael O’Brien, director of global trading at Eaton Vance – an asset manager that has already dipped its toes in the water by posting credit default swap prices on a platform run by UBS last year: “We will look to post up bids and offers when we need to get things done. We find it useful to at least stimulate a conversation about getting a trade done by using an anonymous central limit order book,” he says.

All these firms freely admit their plans may take a while to come to fruition, and may not take a huge bite out of the incumbents’ market share – but in a business where 80–90% of all trades by notional volume have one of just 14 dealers as the counterparty, an influx of new liquidity providers would be a revolution. 

So how far will these changes go? The answers begin with the Sefs themselves – and, more specifically, the requirement that each of them should provide impartial access to all market participants. That means one user has to be treated the same as any other, and be able to make prices as well as take them.

It’s not how the OTC market works today – just over a third of market volume is traded solely between the big dealers, according to statistics published by the Bank for International Settlements last December, and is commonly transacted via the five main interdealer brokers. For market participants that are shut out of this world – and some proprietary trading firms claim they have been refused entry on more than one occasion – it is a paradise of infinite liquidity and tight pricing. To the dealers, the bifurcated market means they can have more confidence in their ability to lay off risks accumulated when trading with clients. 

If dealers and clients are now forced to occupy the same space, trading on the same screens, some market participants believe everyone will be worse off. “Imagine I am a major dealer and you are a large buy-side account,” says the New York-based head of e-commerce at one broker. “You call me up and ask me for $500 million in 10-year interest rate swaps. I source that liquidity in various places but partly in the interdealer market. I might offer you exactly what I can set the trade off with. Now, how do you think I would approach it if that buy-side firm is also on the screen where I source my price information? And also, maybe that buy-side firm is putting in anonymous offers on the screen to influence me to give a better price. If we’re both competing for liquidity in the same market, I may not want to provide it. You can either be a competitor or a customer, but not both, and I think that is at the core of why there has been an interdealer market.”

Some dealers are said to be trying to keep it that way, but not for altruistic reasons. “In interest rate swaps, we have been given strong signals by our dealers that they would be annoyed if we, as a buy-side firm, showed up in the interdealer platforms,” says one US-based hedge fund manager.

Others tell similar stories. One interest rates head at a high-frequency trading firm says no dealer has tried to scare them away from OTC market-making – some have even been supportive – but in other cases, the firm has noticed what it thinks is indirect push-back. The interest rates head says that since indicating interest in joining broker-run Sefs, one dealer has put the brakes on talks to clear for the firm. “It’s just stalled. It’s not moving anymore. And that happened after we told them we wanted to start acting as a market-maker on Sefs,” he says.

A number of other sources at hedge funds and proprietary trading firms say they have also encountered resistance from their dealers. And the implied threat is one that carries weight for the funds, at least.

“I have built relationships with my dealers through a request-driven, bilateral market where they know who they are trading with, and when I go to them they come through for me,” says a senior trader at one US-based hedge fund. “If I am looking for large size, then they provide it at a good price; if I need to lay off illiquid risk, then they will help me do that. These are helpful services, and if they are withdrawn we would feel pain. If a lot of dealers withdraw, then we would feel a lot of pain.”

Short shrift

Others have heard nothing of the sort, and say they would give it short shrift in any case. “They would be restricting market formation by not allowing clients in. That would be against the spirit of the CFTC regulations, which require impartial access to all Sefs,” says Vanguard’s Priyadarshi.

For the proprietary traders, it’s not all Sefs they want access to. Initially at least, these firms do not expect buy-side firms to request quotes from them; instead, they want to join Sefs run by the interdealer brokers, which operate central limit order books of the kind the prop traders currently occupy in cash equities and listed futures. Currently, only dealers trade on these venues, but three proprietary trading firms say they are now in discussions with brokers to gain access, in an acid test for the CFTC’s rules on impartiality. 

Three hedge funds say they are also knocking on the brokers’ doors, and one buy-side lawyer says four of his own clients are going through the same discussions. Even some large asset managers are understood to be in talks to sign up, lured by the promise of deeper liquidity, and it’s something brokers have expected for a while (Risk25 July 2012, page 36 and Risk25 July 2012, page 38). 

But this does not mean the exclusivity of the interdealer market is about to vanish altogether. Impartial access or not, many market participants expect broker platforms to remain the preserve of a small subset of firms – the dealers, plus an assortment of prop traders, hedge funds and asset managers that need huge liquidity and are sophisticated enough to quote prices as well.

“We have spoken to firms that want to know how this will work. They want to know what the workload involved is and if it is worth their time,” says the broker e-commerce head. “So, are we about to go from 50 clients to 5,000? No, we’re not. There are certain things that certain buy-side firms need that aren’t part of the DNA of an interdealer broker.”

There is nothing sinister about this, he says. For disclosed, request-for-quote trading, that most closely resembles the old bilateral world, firms will go to traditional dealer-to-client platforms such as Bloomberg and Tradeweb. These are yet to develop liquid central limit order books so will be less attractive to larger, institutional traders and dealers, which will look to the old interdealer brokers to provide liquid, anonymous limit order books. 

That is why Tradeweb operates two Sefs – DWSef and TWSef. The former is designed to appeal to the interdealer crowd, while the latter is pitched as a more traditional dealer-to-client platform. “DWSef is a more limited universe of participants – we’re catering to clients that are market-making for other participants and need to transfer that risk,” says Lee Olesky, chief executive at Tradeweb in New York. “But we envisage a world where there are non-dealers participating in both of our Sefs. There are plenty of markets where high-frequency firms play a quasi-market-making role. It’s no longer as simple as looking at what type of firm you are – it’s more about your technology, your business model and how you want to trade and access liquidity.”

Smaller firms smell a conspiracy. They claim banks have threatened to pull liquidity from brokers that allow a flood of new clients onto the platforms – and say dealers and platforms tried to bake this into Sef user agreements, which initially prevented firms signing up unless they met certain criteria. Former CFTC chairman, Gary Gensler, clamped down on these so-called ‘enablement mechanisms’ in one of his last acts at the agency (Risk December 2014, page 11). 

And there will still be obstacles for the small group of firms that join nominally interdealer platforms. Brokers have traditionally disclosed the names of counterparties to a trade after execution – a step known as name give-up, which is a holdover from a world where trades were not cleared and counterparties needed to know who they were facing. Buy-side firms want that changed. In part, that’s because they worry they would find it more expensive to hedge if other market participants know what positions they are running, but there are other reasons too. “Ending name give-up on broker Sefs removes the ability for dealers to effect retribution on their clients,” says the US-based hedge fund manager.

Most brokers say they will stop the practice once participants are more familiar with Sef trading and the market settles down. “We will keep it to begin with, because we’re not certain of the system and we want to make sure things run smoothly, but then we will probably get rid of it. A Sef that doesn’t provide for customers that want anonymous trading will lose those customers,” says the broker e-commerce head. 

Some proprietary trading houses say they are also struggling to set up clearing relationships that would support a credible market-making business. If a principal trader wants to clear at CME Group, for example, it will need to ink an agreement with one of the 25 current firms authorised to clear interest rate swaps for their clients – and each of those firms will set risk-based limits on the amount of business a client can do. In futures markets, the costs of clearing directly are lower, and some prop traders clear on their own behalf.

“It means trading firms have not been able to get easy credit. The bar is pretty high. It’s tough for the smaller firms,” says HTG’s Hehmeyer. 

All of this means it could take some time for non-dealer market-makers to show up. Some firms reckon they will be ready in six months, others say they might hold back for as much as five years. That’s partly due to one, final obstacle – particularly for the principal trading firms, there is no point signing up to comatose or dying platforms. Participants want to know there will be enough liquidity to keep them busy, and during the first week of mandatory Sef trading, there was not. According to data collected by the International Swaps and Derivatives Association, cleared US dollar interest rate swaps racked up $221.4 billion in volumes over four trading days and a total of 2,798 transactions. That might sound a lot, but the vast majority was concentrated in a few tenors – on February 20, for example, there were only 50 trades at the seven-year point of the curve.

“A nine-year swap does not trade often. And the reason is that if the 10-year swap trades more frequently, it will be cheaper, so you might as well trade 10-year swaps and manage the risk,” says Simon Wilson, global head of algorithmic rates trading and co-head of counterparty exposure management at Royal Bank of Scotland in London. “I do not think there will ever be the possibility of high-frequency trading firms making markets in nine-year swaps because there just won’t be that many trades in a day.”

As new firms enter the market, Wilson expects trade sizes to shrink and the number of trades to increase. But no-one is willing to guess at how much of this market might end up with non-dealer liquidity providers.

 

BOX: KCG’s eyes on the prize

Among would-be swap market-makers, few firms have so far been willing to nail their colours to the mast and – in some respects – KCG Holdings is no different. Like the rest, the firm wants to see what happens to swap market liquidity, and how rapidly Sefs consolidate. But while it may be holding fire on some details, the firm has been up-front about the end goal – and the timing.

Speaking during its fourth-quarter earnings call on January 31 this year, KCG’s chief executive, Daniel Coleman, said the firm expects to be trading interest rate swaps by the end of 2014. 

“I still think there are too many variables on exactly how it is going to play out for us to prudently invest. I think when the variables are down to one – or one or two – that is when we will be ramping up, and I expect we will be trading swaps before the end of the year. I don’t know if it will be material or big to our revenue at that point, but it is something that we would like to do and something we are focused on,” he said.

It’s not a new idea for the firm. Isaac Chang is global head of fixed income at KCG, and held the same role at Getco, the Chicago-based trading giant that acquired Knight Capital in June 2013, creating the new entity. Over the past two-and-a-half years he has been hiring staff to support the firm’s move into interest rate swap market-making. It’s a trend evident elsewhere as well, say recruitment consultants (Risk December 2012, pages 18–22).

“I have added people with over-the-counter swap modelling and trading experience, but that also have skills that can be deployed in other areas as well. Within our team, we have a critical mass of people with experience that we can quickly deploy when the opportunity comes,” he says. 

The firm is already a big market-maker in cash, options and futures
markets across asset classes, in some cases trading bilaterally with clients and in others posting prices on central limit order books. But in the OTC market, KCG will initially focus on the anonymous order books that are developing at platforms run by interdealer brokers. While all swap execution facilities are required to have an order book, the consensus view is that most clients will stick to the request-for-quote model that more closely resembles current OTC trading practice.

“I have a lot of respect for the effort and infrastructure required by dealers to service institutional buy-side clients,” says Chang. “It is unrealistic for me to expect to go there tomorrow. Instead, we can initially play a role where we are liquidity providers to liquidity providers. That is where we are targeting and where we will likely be this year. So, our focus will be on the anonymous order books and we’ll see if the volumes justify us participating meaningfully there.”

Chang expects liquidity to be deepest in a few, benchmark tenors – two-year, five-year and 10-year interest rate swaps in major currencies. But even that could take time, which is reflected in KCG’s preparations. The firm does not have a clearing bank for OTC derivatives. It self-clears in other markets but has not committed to doing the same for interest rate swaps. 

Being a fully fledged market-maker might also require the firm to register as a swap dealer – something Chang is keen to avoid, unless the revenues justify the associated costs, which he says is not a foregone conclusion. 

“The swap dealer requirements are not onerous enough to stop us, but the opportunity has to match the cost, and there certainly is a cost. If we decide to go down that road, then we have a lot of client infrastructure from what was Knight Capital that will help us comply with know-your-client requirements, reporting, clearing and so on. We won’t rule it out, but I can also envisage a scenario in which a lot of volume moves to futures, meaning we don’t feel the need to participate in swaps,” he says.

 

BOX: Indications of interest

“At a broad level, yes we are interested. For us to provide liquidity we will wait until volumes pick up at the Sefs and then go where trading has consolidated” 

Principal at a Chicago proprietary trading firm

“Frankly, we are just trying to keep our heads above water operationally at the moment. While people have spoken about this as an opportunity, we don’t have the time to devote to it now because we need to ensure compliance with Sefs and the made-available-to-trade determinations. But I could certainly see it happening, either as an explicit business decision or more naturally over time” 

Chief risk officer at a large hedge fund

“I have no interest in being characterised as a market-maker, but I might have an interest in being a liquidity provider. We already have people on our team who can do that and we are interested in showing bids and offers to the market both for our own portfolio and to take advantage of pricing discrepancies” 

Chief operating officer at a large credit hedge fund

“We will make prices on a Sef – or we would like the option to, at least – to be able to source liquidity ourselves as well as take prices from others” 

US-based hedge fund manager