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NEW YORK The $300 trillion privately traded U.S. derivatives markets could be on the verge of the biggest change in their 30-year history if investors embrace new electronic trading platforms that would reduce the market dominance of large banks.
There is newfound optimism among many investors that rules to require swaps to trade electronically will open the markets to new competition, reduce trading costs, and bring price transparency.
Derivatives markets are among the largest in the world, but they remain a market where investors negotiate trades with dealers, instead of allowing investors to trade anonymously with each other. Trading is sometimes infrequent and typically in very large sizes.
Bank exposure to derivatives was a major contributor to the financial crisis that brought down Lehman Brothers and nearly destroyed several other firms. After the financial crisis peaked in 2008, some expected a swift move to exchanges and away from the price opacity of the bank-dominated model.
It didn't happen. Several credit derivatives trading platforms were readied for launch but none succeeded. A European antitrust investigation and a mounting number of lawsuits allege that banks killed a venture planned by Citadel Investment Group and CME Group, and others like it, to protect lucrative revenues they earn from keeping the market private.
Banks have long acted to maintain their intermediary role in fixed income and foreign exchange markets and some are likely to continue to resist trading models that increase competition.
This means that many are likely to favor request-based platforms, known as request-for-quote (RFQ), which are based on bank relationships and replicate how the markets currently work, over order-driven markets that allow investors to bypass them as trade middlemen.
Still, new regulations have also shrunk bank balance sheets and left weaker dealers less able to compete against the largest banks. This means some are likely to support lower-revenue, higher-volume businesses, such as order-book trading, especially if enough investors shift their trades. The new regulatory mandate for electronic trading provides extra impetus.
"Getting the sellside to move away from a very profitable business is going to be difficult," said Charley Cooper, head of exchange-traded derivatives and over-the-counter clearing at State Street Global Exchange, which has a multi-asset trading platform, SwapEx, with an order book and RFQ platform.
"The key way to do that is to attract a significant amount of buyside liquidity," he said. "If the sellside see a resulting drop in their own trading activity because the buyside are trading with each other, the dealers will have to join the platforms to be able to avail themselves of that liquidity."
More standard and liquid contracts such as credit index trades and some interest rate swaps are seen most likely to shift to order books. Derivatives are used to protect against losses or to speculate on moves in credit, interest rate and other assets.
But progress may be slow. The launch of multiple trading platforms will fragment liquidity. Eleven platforms have applied to trade swaps since the Commodity Futures Trading Commission (CFTC) last month finalized long-awaited trading rules that take effect in October, and more platforms are expected. The rules require all trading venues to offer an order book.
Many investors are also accustomed to dealing with banks and smaller users have been exempt from clearing and trading rules. It is also easy to modify trades to avoid clearing and trading mandates, with capital rules governing non-cleared trades not expected to come for years.
"You would need a much more diverse community of end-users for central-limit order books to be successful. For that to happen you would need to have a dramatic reduction in average trade sizes of contract sizes at the very least," said Paul Rowady, a senior analyst at TABB Group.
RFQ systems are likely to remain in demand for larger or more customized trades, which are less liquid and benefit from more negotiation, even if order-book trading gains traction.
Electronic trading may be the derivatives reform that threatens bank revenue the most. JPMorgan Chase & Co, the largest U.S. bank by assets, said last year that interest rate swaps and credit trading are two of its highest earning markets, generating on average $350 million and $375 million, respectively, in revenue each quarter.
Around 30,000 interest-rate swaps earn the bank around $12,000 per trade while 250,000 credit trades generate $1,500 per trade. By comparison, the bank trades about 10 billion shares in the U.S. cash equity market, earning it around $150 million per quarter at 1.5 cents per share, JPMorgan said.
The emergence of a new trading regime comes at a time when banks face fresh allegations they thwarted past credit trading ventures, using broad market controls to protect their business.
Large banks own and influence all key parts of the market infrastructure, from clearing, data, documentation, licensing, and settlement to trading systems and flows.
Benn Steil, senior fellow and director of international economics at the Council on Foreign Relations, who has consulted on trading platforms, said the banks use a combination of ownership restrictions, revenue-sharing agreements with trading platform providers, and regulatory arbitrage to remain dominant.
"The whole distinction between buyside and sellside is an anachronism; in an electronic environment it no longer makes any sense," he said.
The U.S. Department of Justice has been investigating potentially anticompetitive behavior in the credit derivatives market since 2009, focused on clearing, trading and information services. Its enquiries have included whether banks used their ownership and sway over trading platforms to control flows and restrict competition, said two people familiar with the probe.
Tensions between market participants have flared on several occasions since the crisis, with wrangling over clearing and trading details delaying reforms.
Large fund managers and others pushing for reform say banks are restricting direct participation in clearing and trading, attempting to reduce the trade anonymity of investors using documentation and other means and slowing technology needed to move to new systems.
Banks have countered in industry meetings and interviews by saying that trading and clearing technology needed time to develop and that certain documentation and systems are needed to ensure trade acceptance by clearinghouses. None would speak on the record for this story.
OPENING THE MARKETS
If order book trading does catch on, the markets could change dramatically.
In open access platforms, investors can set limit orders, standing orders to buy or sell at a set price, which compete with dealer prices. That can sharply reduce costs, as was seen when stock markets included a shift from RFQ to order books, where trading costs ultimately fell as much as 95 percent.
"History has clearly shown that whenever you have order books enter a marketplace you see an immediate increase in liquidity and transparency and lower the cost for both buyside and sellside alike," said Jamie Cawley, head of Javelin Capital Markets, a rate and credit derivatives order book and RFQ.
Trade anonymity would also reduce the advantage banks have in seeing client positions, as many fund managers have complained that request-based systems require them to reveal trading strategies.
"I don't know of a marketplace as large as the swaps market that trades RFQ," said Christian Martin, head of TeraExchange, a multi-asset order book and RFQ. "Information leakage is a significant problem for participants on a RFQ platform and they can avoid that completely on a fully anonymous platform."
If trading remains dominated by the RFQ model, meanwhile, the largest banks are likely to maintain much of their market share, and price transparency may remain limited.
The CFTC finalized a controversial rule in May that requires investors to seek two price quotes on RFQ platforms before entering trades, rising to three after a year. That has brought complaints that the rule favors the incumbent banks - because it is likely to tie investors to the few banks that already offer the most liquidity and limits price transparency before trades, which is critical to drawing in new entrants.
(This story corrects spelling of name in ninth paragraph)
(Reporting By Karen Brettell; Editing by Tim Dobbyn)