KCG expects to start trading interest rate swaps by year-end

Fri Jan 31, 2014 4:46pm EST

* KCG reported Q4 a loss of 15 cents a share

* Call to end rebates for market makers won't gain traction-CEO

* Firm expects $41 mln on closing of BATS/Direct Edge merger

By John McCrank

NEW YORK, Jan 31 (Reuters) - Trading firm KCG Holdings Inc , which reported a quarterly loss on Friday due to merger costs, plans to trade interest rate swaps before the year is out, the company's chief executive said.

Interest rate swaps, which allow investors to hedge against interest risk, make up $490 trillion, in notional value, of the $633 trillion over-the-counter derivatives market. Much of the swaps market is moving onto new exchanges known as swap execution facilities (SEFs), as required by the Dodd-Frank financial reform bill, representing an opportunity for trading firms like KCG.

The move to SEFs will bring more electronic trading, as opposed to brokers trading between themselves over the phone, to the over-the-counter derivatives market, and is aimed at boosting transparency.

"I do believe that transparency in swap trading will be beneficial to all market participants who trade interest rate products," KCG chief executive Daniel Coleman said on a call with analysts. "It's something that we would like to do and something we are focused on."

Under the new rules, swaps must also be centrally cleared, meaning clearing houses back the trades against a default, opening up the market to firms that do not need massive balance sheets to stand behind the trades.

The OTC derivatives market came under regulatory pressure in the wake of the financial crisis when risky trading at firms such as insurer American International Group Inc and investment bank Lehman Brothers nearly toppled the financial system. The inability to assess the scale of the market, the identity of contracting parties, or the nature of non-standard contracts, frustrated regulators.

MARKET STRUCTURE

More recently, there have been growing calls for an overhaul of U.S. equity market regulation in order to reduce conflicts and complexities in the system.

One of the loudest voices as of late has been Jeff Sprecher, who heads IntercontinentalExchange Group, the new owner of the New York Stock Exchange. Sprecher has called for an end to the dominant pricing system in U.S. equities, in which market makers receive trading rebates for posting orders to exchanges for other market participants to trade against.

As one of the top U.S. equity market makers, KCG made around $48 million in profit on just under $233 million in market-making revenues in the last quarter.

Overall, the firm, which also operates dark pools and provides trading services in multiple asset classes and countries, reported a net loss of $17.4 million, or 15 cents a share, on $322 million in revenues. The loss included $36.5 million in merger and integration costs.

The pricing system, known as "maker-taker," in which the "maker" of the liquidity on the exchange receives a rebate and the "taker" - the buyer of the stock - pays a fee, is "bad for markets," Sprecher told Reuters last week.

He said the system attracts people who quickly jump in an out of markets looking to profit from rebates, rather than actually trade or hold risk. He said the rebates distort stock prices and cause the interests of brokers to be out of sync with their customers.

Coleman said that ultimately maker-taker is the way exchanges compete with each other, and that if rebates are removed, exchanges would still compete on taker fees and brokers would still face the conflict of routing one exchange versus another based on fees.

"You have the head of a commercial enterprise saying he doesn't want to compete on fees any more ... so from that point of view, I don't think that argument is going to gain a lot of traction," he said.

KCG said that at the end of the quarter it received around $10.5 million from Nasdaq OMX Group as part of the exchange operator's compensation plan for the botched Facebook IPO in May 2012. During the IPO, a glitch in Nasdaq's system prevented timely order confirmations for market makers, leaving them unsure about their exposure for up to days afterwards.

Knight Capital Group, which merged with rival firm Getco last summer to create KCG, recorded a charge of $35.4 million in the second quarter of 2012 related to the Facebook IPO.

Knight had its own glitch in August 2012, which led to millions of unintentional orders flooding into the market over a 45-minute period, leaving the firm with a huge position it had to unload at a total loss of $461.1 million. KCG agreed in October to pay a fine of $12 million over the incident.

Separately, KCG said it expects to receive $41 million as part of a dividend payment once exchange operators BATS Global Markets and Direct Edge close their merger, which is expected to happen within days. The deal cleared its final regulatory hurdles on Friday. KCG owns stakes in both BATS and Direct Edge.

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