Electronic Market Microstructure

SWAPS are on the electronic move! (again…) With the recent purchase of Swapstream by the CME, the past release of PBWire by SwapWire, and the increasing use of ICAP’s I-Swap & FRA-Cross, we are seeing some encouraging movement in the electronic derivative space again. It seems that the ever increasing success of electronic trading in both the equity and fixed income markets are pressuring many participants to accelerate the implementation of interest rate swaps electronic capabilities. The SWAPS market has been ready for a renovation for a longtime. After all, trading, confirmation, and processing remain highly manual, while brokers continue to reap some of their largest fees from interest rate swaps. The market needs to get it right this time and delivery the following things:

• Increased market transparency. Multi-dealer platforms can function as anonymous liquidity aggregators, providing a deeper view of the market while tightening spreads.
• Significantly reduced transaction costs. Technology and reduced overhead allows these firms to offer significantly reduced brokerage fees. While none of the firms Celent spoke with would disclose exact fee schedules, all maintained that they offered deep discounts (as much as 50 percent) against prices charged by traditional voice brokers.
• Increased operational efficiency via straight-through processing (STP). Firms will see an overall reduction in operational overhead and error rates through increased STP integration.
• Decreased Operational Risk & Increased Relief on Reg. Capital: again, operational improvements that decrease error rates will allow firms to reduce Basel II-mandated capital reserve requirements, making swap trading significantly less capital-intensive.

Although swaps, like other OTC derivatives, can be highly customized financial instruments, many are the same and the industry felt that the swaps market was sufficiently standardized to be traded online. In response, several platforms have been implemented and promised to make the swap market markedly more efficient. To be fair the first attempt was not promising; The majority of these initiatives failed to attract significant interest from the market. The past 2 years have seen a “renaissance” in electronic swap trading initiatives, and things seem to be moving in the right direction.

CME’s acquisition of Swapstream expands the CME into global SWAPS trading. Swapstream is a neutral inter-dealer platform that supports the trading of SWAPS and is considered an ATS governed by the Financial Services Authority (FSA). Swapstream will help penetrate the fast growing $164 trillion in notion value OTC SWAPS market. Swapstream established market position of offering the greatest liquidity available and innovative functionality and CME’s global distribution, post-trade processing and clearing capabilities is a very synergetic match.

ICAP is the world’s largest electronic inter-dealers broker and is seeing great success with both their i-Swap and FRA-Cross products. i–Swap is an electronic booking model for provides a sophisticated view of liquidity, strategy trading, and STP for better execution. FRA-Cross provides a matching system so that traders can hedge their reset risk efficiently and cheaply.

SwapWires PBwire product allows firms to “give-up” their SWAP trades to other executing brokers. These so-called give-ups trades are cleared through other brokerages without the worry of the originating dealer. This service is becoming very popular with hedge funds as it becomes getting instantaneous execution to them which significantly reduction in the possibility of operational and trading risk.

If technology innovation and business collaboration continues we should see a markedly increase in SWAPS electronic trading which my pave the road for other derivatives.