October 2, 2013 / 5:33 PM / in 4 years

Swap exchanges launch in threat to Wall Street profits

WASHINGTON, Oct 2 (Reuters) - More than a dozen new U.S. exchanges opened their doors for clients on Wednesday, marking the start of regulated trading of derivatives in a threat to one of Wall Street’s most lucrative businesses.

Business may be tepid at first, because the bulk of the $630 trillion market will slowly move over to the exchanges in the coming months, as part of a gradual implementation of the Dodd-Frank law to overhaul Wall Street.

Moreover, the Commodity Futures Trading Commission, which regulates the so-called swaps - used to offset risk, but mainly to speculate - has just sent virtually all of its people home as part of the U.S. government shutdown.

But in the long run, the exchanges are a credible threat to a highly profitable business for banking behemoths such as JP Morgan Chase & Co, Citigroup and Bank of America , who dominate this market.

“Starting next year, it’s showtime,” said Will Rhode, an analyst at the TABB Group, a research and advisory firm specializing in financial markets.

The swaps business generates an estimated $40 billion in annual revenues for the fixed income divisions of Wall Street banks, but the new rules drawn up after the 2007-09 financial crisis put that number at risk.

The new exchanges - called Swap Execution Facilities (SEFs) - allow clients to trade directly with each other, rather than having to go through the banks. That will open up competition and is expected to lower prices.

“We’ve been in communication with virtually all of the providers of these platforms,” said Jamie McConnel, who works at Chatham Financial, a firm that advises users of swaps about regulation and technology.

“We may sign up with multiple SEFs. In the early stages it may not be who is the best, but a shotgun approach to ensure that you have that relationship.”

NEW RULES

The SEFs are run by firms that are already large swaps brokers, such as ICAP and GFI, but also by new entrants such as Bloomberg LP and Tradeweb, which is largely owned by Thomson Reuters.

Swaps are financial contracts that enable clients to offset risk. One commonly used example is an exchange of fixed interest rate payments for floating payments. Such deals can be highly customized and are often of large value.

They are negotiated privately, often over the phone, and rose to prominence during the 2007-09 financial crisis, when it turned out they had been used in highly complex financial constructs into which regulators had no insight.

The new rules put an end to that, even if voice trading will still be allowed, as long as buyers and sellers can prove they have spoken to more than one counterparty.

Swaps will need to be routed through traffic control centers known as clearing houses, which take on the risk that one of the market parties fails to pay. This spreads the risk and means that firms other than cash-rich banks can now also offer these trades.

The change will break open what the TABB Group recently described as a “gated community” of investment banks who set prices in an opaque process amongst themselves, with clients unable to shop around for better prices.

The group cites an example it says is typical of a bank charging $20,000 to execute a trade on a $100 million interest rate swap, a common size. It is a large amount of money for what comes at a low cost for the bank.

The new SEFs will likely try to attract clients by offering lower prices, TABB says, helped by the CFTC’s rules that say that as soon as one SEF offers a product, all others also need to make it available to trade.

MARKET OPENS UP

The large swaps brokers also need to fight for their business. They have traditionally mediated swaps deals between banks, while staying away from going after the banks’ clients - now the most promising customer segment.

The largest fund managers, who are also heavy users of swaps, have sometimes taken a more cautious approach to the changes because they are used to trading swaps in very large sizes, which may become harder under the new rules.

They have often been treated well by the largest banks, two derivative brokers said, getting good prices and enjoying long-standing relations with their banks that enabled them to execute highly customized deals confidentially.

More clarity about where swaps prices are headed will transpire in the coming months, when more instruments will start trading on the platforms and customers gradually decide who they want to do business with.

Still, the cumbersome process of bringing swaps back into the oversight fold - after they were exempted at the height of the deregulation wave in the 1990s - was too slow, some said, weighed down by persistent bank lobbying.

“The whole industry has a stake in preserving opaque markets ... That’s their raison d‘etre, that’s their modus operandi, that’s who they are,” said John Parsons, an academic at the Massachusetts Institute of Technology.

“That’s where their money comes form. They don’t want a transparent system. They could create it instantly.”

Our Standards:The Thomson Reuters Trust Principles.
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