- Dodd-Frank sets onerous registration process on market makers
- Executives want to see market evolve to exchange trading
Some of the biggest computerized-trading firms are facing obstacles as they try to move into interest-rate swaps, a $381 trillion market that has yet to be dominated by automated buying and selling.
Regulations passed after the financial crisis that should make the interest-rate swaps market a more natural fit for electronic market-makers also created barriers to entry. Under the 2010 Dodd-Frank Act, market makers must register as swaps dealers, an onerous and expensive process, or agree to never deal in swaps that aren’t guaranteed by a clearinghouse, something most firms don’t want to do. High-speed firms are also grappling with the pace of trading and the size of transactions in the market.
One firm that’s already made a move is Citadel LLC, which last year began making markets in rate swaps. Hudson River Trading, Virtu Financial Inc., KCG Holdings Inc. and DRW Trading Group are all at various stages of heading into swaps, according to four industry executives who asked not to be named in order to discuss their strategy. If they succeed, they would transform a derivatives market that has been the domain of major banks since its inception in the early 1980s.
“Citadel is paving the way for other market makers,” said Michael O’Brien, director of global trading at Boston-based mutual-fund company Eaton Vance Corp. As swaps users become comfortable receiving quotes from the market-making unit of the Chicago firm, they will probably become willing to use other non-bank trading firms, he said.
Proprietary trading firms would like to see the swaps market move toward an exchange-traded model before becoming engaged, the executives said. The current electronic version of swaps trading, called request for quote, isn’t well-suited for computerized firms because it involves traders negotiating prices rather than computer programs deciding when to buy and sell. Stock and futures exchanges use what’s known as a central limit order book to match customer orders.
The size and speed of the market is also an issue for proprietary traders that specialize in making small trades thousands of times a day. The over-the-counter derivatives market is used to hedge or speculate on price changes in everything from credit to commodities. Because of that trades can be much bigger than in equities or currencies, with companies looking for transactions as big as $1 billion. Trades that large are riskier for a market maker and they also take place less often.
Swaps trading operates at a slower pace than in the $30 trillion futures market, where automated firms have established a major role as intermediaries. More than 3,800 interest-rate derivatives, including swaps, traded every day in 2014, according to the International Swaps & Derivatives Association. Interest-rate futures on CME Group Inc. traded on average seven million times a day in the same period.
“Evolution in these large, episodic markets is slow,” Laurent Paulhac, chief executive officer of ICAP Plc’s Swap Execution Facility, said in an interview. “In swaps, there’s plenty of time when there’s no execution. Then all of the sudden there are market participants who need and want to trade and, boom, they trade. That’s what we call an episodic market.”
Citadel is active on seven interest-rate swaps platforms and trades using request-for-quote on two of them. Paul Hamill left UBS Group AG in 2014 to help the market maker with its ambitions for interest-rate swaps.
“KCG is constantly evaluating opportunities to provide liquidity across various products and asset classes,” Sophie Sohn, a spokeswoman, said in an e-mailed statement. “We believe a diverse set of participants in any market is positive for both investors and for the markets as a whole.” Representatives from Hudson River and DRW declined to comment.
Another headache for electronic market makers is the wide array of swaps with varying attributes such as their date of maturity. That makes it harder to offset one trade with another and can leave a firm with unwanted risks in its portfolio.
There are other inconsistencies to overcome. While Virtu can operate in many different over-the-counter markets, the current system in rate swaps with different prices for trades done over the phone and those done electronically on swap-execution facilities “creates unrealistic gaps in pricing and that in turn creates impractical risk,” John Shay, senior vice president at Virtu, said in an e-mailed statement.
“Once these risks are mitigated, Virtu expects to be a meaningful player in these markets,” he said.
The current market structure prefers large transactions in the RFQ model, said Hirander Misra, chief executive officer and co-founder of interest-rate futures platform Global Markets Exchange Group International LLP. He was previously chief operating officer of Chi-X Europe Ltd., which he helped to found.
That’s “kept it in large part away from the central limit order book type structure which high-frequency trading firms thrive in, in equity and futures markets,” he said.