Sefs find liquidity comes at a cost

Banks have been reluctant to pick winners and losers from the array of new derivatives trading platforms being set up, but with Citi and Morgan Stanley taking equity stakes in two venues at the end of last year, it looks like some dealers are finally making their minds up. By Tom Newton

The rules of musical chairs are simple: participants walk round a set of chairs while music plays. When the music stops, everyone has to sit down. The drama is added by the fact that there are fewer chairs than people, so slow movers miss out and have to leave the game.

Would-be swap execution facilities (Sefs) have been playing their own drawn-out version of musical chairs for the past three years. Many have given up and gone home. Despite initial estimates that the Dodd-Frank Act would give birth to dozens of these over-the-counter derivatives trading platforms, only 18 have so far registered with the National Futures Association – but for these firms, the game is about to get serious.

“Everybody has been dancing around each other, eyeing each other and eyeing the chairs. The music’s going to stop soon and we’re all going to have to grab a chair. Somebody’s going to get left out,” says Ron Levi, chief operating officer at interdealer broker GFI Group in New York.

The winning platforms will be the ones that can attract market-makers – that’s true for the Sefs as well as the new exchanges that have been set up in response to the changing regulatory environment, such as TrueEx and Eris Exchange. But, so far, dealers have been keeping their cards close to their chest. Then, on December 20 last year, two broke cover. Citi announced it had taken an equity stake in i-Swap, the platform launched by interdealer broker Icap in 2010, while Morgan Stanley bought a slice of Eris.

In its own way, each deal was significant. Morgan Stanley is rumoured to have as much as a 5% stake in Eris – an interest rate swap futures exchange that launched in 2010 with the backing of a group of Chicago-based proprietary trading houses, including DRW Trading and Getco, but had failed to sign up any bank market-makers. In part, that lack of support is because the swap future product competes directly with the over-the-counter swaps that have been so lucrative for dealers.

The music’s going to stop soon and we’re all going to have to grab a chair. Somebody’s going to get left out

The launch of another swap future contract by CME Group at the start of December – based on a patent owned by Goldman Sachs – is said to have galvanised both Eris and Morgan Stanley (Risk October 2012, page 6). Both firms declined to comment.

Meanwhile, the Citi transaction saw it join existing dealer shareholders Bank of America Merrill Lynch, Barclays, Deutsche Bank and JP Morgan in a venture that has split the dealer community in two – its rival platform, Trad-X, is owned by Tradition Financial Services and was launched in 2011 with backing from 11 dealers, on the basis of a revenue-sharing agreement. Citi is thought to be the first bank to be part of the inner circle at both platforms.   

These commercial alliances give the market-makers an incentive to support each venue as liquidity providers, and in each case, the transaction went hand-in-hand with an agreement to act as a market-maker: Eris trumpeted Morgan Stanley’s “commitment to stream two-sided markets across the yield curve”, while Icap made it clear that Citi would “support the platform with streaming prices”.

So, is this the tip of the iceberg? Sort of, says the head of fixed-income e-commerce at one large US bank. There are conversations going on, he says, but the usual iceberg rule – that 10% can be seen while a far larger mass is hidden from view – is not quite true when it comes to strategic investing in the Sef market.

“There’s a fair amount going on behind the scenes. I’m not sure the iceberg rule applies – I’d say it’s more a 50-50 split. About half of what’s going on is already public,” he says.

There are plenty of rumours flying around, though. TrueEx, for example, is said by a source close to the firm to have received several overtures from large dealers interested in taking an equity stake.

Icap, meanwhile, has reportedly been making eyes at UBS’s price improvement network (Pin) – a single-dealer credit default swap (CDS) platform that allows clients to trade with the Swiss bank’s trading desks, or directly with each other (Risk January 2013, pages 74–75). It’s an innovative move for the OTC market and has been a success story so far, but dealers are barred from owning more than a 20% share of a Sef, so the bank needs to restructure the venture in some way – either by reducing its ownership, or by turning it into an aggregator of other platforms, which are not subject to bank ownership restrictions. The latter course of action would require the bank to stop making markets on Pin – although it could provide liquidity to venues that are accessible via the service.

While the bank has said in the past that aggregation is the route it plans to follow, three different market participants claim to have heard of Icap’s interest. The problem for the broker is that Pin would give it a way to interact directly with bank clients, and the dealers have always tried to keep the interdealer brokers as just that – interdealer.

“If I were a dealer and Icap connected with UBS Pin, I would stop sending any prices to Icap because it would mean UBS is taking my prices to communicate to their customers. We think the dealer community would be extremely upset – that would seem to be a suicidal decision,” says a senior source at another broker. Both UBS and Icap declined to comment on the rumours.

Separately, Tullett Prebon is said to be busy behind the scenes, with market participants claiming the broker is trying to build a consortium of dealers to support its own Sef venture. The firm also refused to comment.

But equity investments may not reveal as much about the market’s winners and losers as is generally assumed. Jodi Burns, a senior director for market analysis and development at foreign exchange trading platform, FXall, says it doesn’t follow that Sefs with dealer investment will have the most liquidity.

“There’s a hypothesis that if the banks have some financial stake in your platform you’ll see a piece of their liquidity. That’s not always true though. If the bank owns 1%, then the stake is not meaningful enough to justify adding liquidity if it’s not in the interests of the bank,” says Burns.

Instead, some market participants characterise the stakes as a defensive play – for both the seller and the buyer – and argue the banks could be driven by a desire to cement some influence over potentially vital components of the new OTC market structure. “It’s great to have investment from dealers, but what’s the price you pay?” asks the chief executive of one trading venue in the US.

That kind of argument is fairly common among incumbent multi-dealer platforms – they already have liquidity, do not need to give up ownership to dealers in order to stay in business, and are using that as a selling point. Tradeweb, which was originally set up by dealers, and remains part-owned by the industry, is the exception in those terms, but all these players – Bloomberg, FXall and MarketAxess are other examples – share the advantages of incumbency and maturity. None is likely to find itself without a chair when the music stops.

“There will be an incumbency of incumbents. Piercing this veil and becoming a new entrant in some of these platforms will be increasingly difficult. You need a lot of capabilities, you need a convergence of users – it’s tough,” says Paul Rowady, a senior analyst with Tabb Group in New York.

Jim Rucker, chief risk officer at MarketAxess in New York, agrees. “I think if you look at where e-trading in swaps is gravitating today – and there’s a fair amount already taking place in interest rate swaps and CDSs – it’s occurring around the existing venues. I personally don’t see why the current rules are likely to change that,” says Rucker.

But just because these firms – and the brokers – are established, it doesn’t make it impossible for start-ups to gain a foothold. In some cases smaller, more nimble platforms may be able to source liquidity through non-traditional means.

“For the smaller players, innovation is the key. That’s likely to be their competitive edge and best hope of grabbing a chunk of liquidity,” says Bradley Wood, partner at consultancy GreySpark.

Wood points to examples of start-ups that are trying something new, such as SurfacExchange, which dynamically builds an order book on the back of a request-for-quote system. Other platforms can offer a deep roster of existing buy-side users, or try and help the buy-side to become liquidity providers themselves.

However, it’s still a daunting challenge for new entrants, no matter how good their ideas.

“The reality is a lot of these start-ups find it difficult to get traction on the client side. Building up client knowledge and relationships is a very long-term project. You can’t just walk in and expect 300–400 institutional investors to take the trouble and expense to connect to your system,” says Robert Hammond, head of sales and dealer relationship management for Europe and the Middle East at MarketAxess in London.

Tabb Group’s Rowady says it will be hard for clients to move away from the existing dealer-client relationship. “Some clients lean very heavily on their dealer and will want to maintain that relationship. It’s naive to think the full complement of end-users is all of a sudden going to feel comfortable entering complex trades into an e-trading platform,” he says.