Digital Swaps Fuel Confirmation Race to Cut Weeks to Seconds
Intercontinental Exchange Inc. (ICE), ICAP Plc (IAP) and a joint-venture between Markit Group Ltd. and the Depository Trust & Clearing Corp. are building systems that the firms say will seek to cut the time it takes to confirm swap trades to less than a second.
The companies are targeting the first quarter to start the streamlined confirmations, which ensure trades in the $648 trillion market are legally binding, as the buying and selling of swaps evolves from privately-negotiated transactions over the phone to being executed on automated systems where investors may not know who is on the other side of the deal. As late as 2005, some trades took as long as 17 days to complete.
“It’s a great example of how this market is radically changing,” said Will Rhode, director of fixed-income in New York at Tabb Group, a financial-markets research and advisory firm. Unlike futures contracts, where investors execute and clear at the same exchange, swaps trading will be “a fragmented marketplace” with many options of where to buy, sell and clear the contracts, so “you need some certainty” that the trade will be accepted, he said.
The Dodd-Frank Act, which overhauled U.S. financial-market regulation in 2010, mandated that most interest-rate, credit-default and other swaps trade on so-called swap execution facilities or exchanges as a way to improve price transparency.
That opens the possibility for money managers to trade between themselves because the transactions will be backed by a clearinghouse, cutting dealers out of the equation and making it necessary to approve credit limits and trade size prior to buying or selling a swap.
Mandated trading of swaps on automated systems is expected to begin for transactions between dealers in the first quarter of 2013, with trades between banks and their customers to follow later in the year.
Before a swaps trade is completed, a credit check verifies that a bank customer such as a hedge fund is not exceeding a pre-determined risk limit. Investors and banks often conduct offsetting trades after a swap to hedge their risk from the transaction. If the original trade is rejected, that hedge can become an exposure.
MarkitServ, the joint-venture between Markit and the DTCC, is building a credit-limit hub with a goal to perform those checks within 5 milliseconds, said Jeffrey Maron, a managing director for the firm in New York. The system won’t disclose the identity of counterparties to the trade and will allow traders the flexibility to spread their business around multiple venues, he said.
“You shouldn’t fracture a client’s credit line,” he said in a telephone interview. By year-end MarkitServ will have a working version of its process in place and will be fully operational by the end of March, Maron said.
That’s a sea change from how the market operated just seven years ago.
In 2005, at the urging of Timothy Geithner, then the president of the Federal Reserve Bank of New York, dealers agreed to begin streamlining how credit-default swaps were handled after a trade. By 2009, they cut the amount of time it takes to confirm trades to less than a day.
With Intercontinental’s Plus One initiative, the credit and margin check is done after the trade is executed, so the transaction won’t be slowed down or face the possibility of rejection, said Peter Barsoom, chief operating officer of ICE Clear Credit. “Our target is going to be that that takes seconds, not minutes,” he said.
Intercontinental won’t be able to complete the design of Plus One until the final rules governing swap execution facilities, or SEFs, are complete, Barsoom said. It plans to have the system active in 2013’s first quarter.
ICAP’s Traiana subsidiary is building its Harmony CreditLink system for pre-trade credit-checks for interest-rate and credit swaps that it hopes to have completed by early 2013, Andrew Coyne, chief executive officer, said in a telephone interview.
“The whole of the market ever since the crisis has been focused on managing credit risk” and confirmation systems will extend that management to a dealer’s clients, he said. The company’s goal is to provide the service in milliseconds, he said. “Because you don’t know who you’re trading with, you can’t get into a situation where there’s a dispute,” Coyne said.
A one-stop, credit-limit check introduces new risks for the swaps market if that hub goes down, Barsoom said.
With dozens of SEFs and nine clearinghouses so far expected to compete for a slice of the regulated swaps market, the benefit of one service connecting all of them is important, MarkitServ’s Maron said.
“We fully expect the market’s going to hold us to a very high threshold” and the company has back-up plans in place, he said. “The risk you’ve got of maintaining 25 concurrent connections is significant too.”
While the swaps market won’t be trading at lightning speeds tomorrow, once the new electronic systems are in place the buying and selling will only get faster, making trade confirmation more important, Rhode said.
“They’re clearly anticipating what the world might look like in five, 10 or 50 years,” he said.
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