Swaps Revolution Falling Flat as Brokers Keep Grip on New Market

Meet the new swaps market. Same as the old swaps market.

U.S. lawmakers and regulators sought to transform the $693 trillion over-the-counter derivatives market by bringing transparency and competition to a historically private part of the financial industry that worsened the 2008 credit crisis. Loosening banks’ grip over trading was a top priority for Gary Gensler, who oversaw the shift as chairman of the Commodity Futures Trading Commission.

Two weeks after the regulatory shift related to the Dodd-Frank Act took effect, there’s been little change -- and little indication that it’s coming. Banks are trading interest-rate swaps exclusively with banks in one area, while buyers and sellers such as money managers are doing business in another, according to seven people with direct knowledge of the matter, who asked to not be named because they’re not authorized to speak on the topic publicly.

“The walls are not coming down,” said Will Rhode, director of fixed-income research at Tabb Group LLC, a New York-based research and advisory firm. “It’s the status quo, and it will be the status quo through 2014.”

Prior to being regulated under Dodd-Frank in 2010, swaps were bought and sold over the phone or electronically between banks and their customers. The dealers then used interdealer brokers such as ICAP Plc or Tullett Prebon Plc to arrange offsetting trades with other banks, benefiting from a wholesale market that their customers couldn’t access.

New Venues

Beginning Feb. 15, the CFTC moved to undo that system by making it illegal to restrict who could trade rate contracts on swap execution facilities. SEFs are aimed at giving investors a better chance to buy and sell swaps with each other rather than banks, potentially increasing competition and cutting costs.

To date, SEFs owned by six interdealer brokers are dominating volume for rate swaps. About 96 percent of the contracts that changed hands in the five-day period that ended Feb. 28 traded on SEFs owned by ICAP, Tullett Prebon, BGC Partners Inc., Cie. Financiere Tradition SA, GFI Group Inc. and Tradeweb Markets LLC’s Dealerweb unit, according to data compiled by Clarus Financial Technology.

The other 4 percent were traded on SEFs owned by Tradeweb, Bloomberg News parent Bloomberg LP, TrueEX LLC and Javelin Capital Markets LLC, according to Clarus. That part of the market is where asset managers and hedge funds are trading, the people said.

The pattern was similar the week before, when 93 percent traded on interdealer broker SEFs, according to Clarus.

Lehman Crisis

With interest-rate swaps, investors agree to make either fixed or floating payments to each other. As rates rise above the agreed-upon fixed level, for example, floating payments increase, making money for the holder of the fixed-rate leg of the trade. Pensions and insurance companies use them to protect against investment losses caused by a higher interest rate environment.

Before they were regulated, swaps made it more difficult to know the degree to which banks were interconnected, a key reason why the U.S. government was forced to bail out the financial industry once Lehman Brothers Holdings Inc. collapsed in September 2008.

During the first week following the transition to electronic trading, volume for rate swaps sank between 30 percent and 40 percent, according to Tabb, which analyzed data from Clarus, Depository Trust & Clearing Corp. and the International Swaps & Derivatives Association. Volume surged about 40 percent during the second week, Tabb said yesterday.

‘Just Paint’

Representatives of the SEFs declined to comment. Steve Adamske, a CFTC spokesman, said the agency didn’t want to comment after only two weeks of SEF trading.

“We are looking at the trends, as well, and what is going on,” Adamske said.

Regulators over the last four years have battled derivatives industry opposition on the SEF rules meant to create a less restricted marketplace. Gensler, who stepped down in January after his term expired, made open access a top priority. In November, he warned SEFs owned by interdealer brokers that they must ensure everyone could use their systems.

“You can’t just paint on the outside of an old interdealer broker the letters S-E-F and say you’re a swap execution facility,” he told reporters at a Nov. 18 event in New York. At the same time, he said, SEFs owned by Tradeweb, MarketAxess Holdings Inc. and Bloomberg LP were formulating rules that gave banks too much control over whom their customers could buy and sell with. All three firms subsequently revised their regulations to address that concern.

Building Connections

The SEFs owned by the interdealer brokers aren’t acting illegally. The market’s traditional structure could simply be slowing the full adoption of regulators’ vision.

Traditionally, asset managers such as Fidelity Investments and interdealer brokers never interacted in the rate swaps market, meaning there was no existing infrastructure or agreements linking the two groups. The sides are still working to make those connections, according to four of the people who requested anonymity.

Some of the largest swaps investors are proceeding cautiously as electronic trading gets started, only placing orders through companies they’ve dealt with previously, according to the seven people familiar with the matter. For asset managers, that means going to dealer-to-customer systems like Bloomberg LP, Tradeweb or MarketAxess.

Psychology Shifts

There’s also a shift in trading psychology that is under way at asset managers, the people said. In the past, banks told investors what the price to buy or sell a swap would be, and it was up to the asset manager to accept or reject it. Yet on SEFs, investors need to adjust to putting their own prices out to the market and their trading strategy is changing to reflect a more active role in the transactions, the people said.

Not all rate swaps are required to trade on SEFs, creating another damper on the transition to electronic trading. In February, the CFTC gave a three-month delay for rate-swap trades that consist of multiple components. That section of the market comprises about 25 percent of all trades, said Tod Skarecky, a senior vice president at Clarus who runs the SEF data aggregation service for the firm.

The other major recent shift in the swaps market, moving most trades into clearinghouses, was much more popular because it reduced the risk of your trading partner going bankrupt, said Kevin McPartland, head of market structure and research at Greenwich Associates in Stamford, Connecticut. The banks and investors active in the swaps market are less sure of the benefits of changing how the trades are actually done, he said.

“People moved to clearing voluntarily, and we just don’t have that with SEFs,” he said. On interdealer broker SEFs, “the process has barely changed at all, except the trades get reported.”

The shift to an even playing field will only come about if asset managers and other investors see cheaper prices in the bank-only part of the market, McPartland said.

“There needs to be an economic incentive,” he said. “I’m not sure the market sees that yet, but it will come.”

Before it's here, it's on the Bloomberg Terminal.