Swap dealers are often described as an oligopoly – or, less politely, a cartel. It's easy to understand why. The vast majority of the market is divvied up between a dozen-or-so banks, and they enjoy a lot of control over some of its protocols and practices – but what's happening in the euro swap market offers an interesting counterpoint.
For big clients, bid/offer spreads have barely widened over the past year, during a period in which liquidity has been draining from the dealers' go-to hedges. The interdealer market is less deep than it was, as is the Bund futures market. In both cases, banks claim the size of trade they can execute for a given spread is roughly half what it was a few years ago. Put crudely, banks face a choice between hedging immediately – and paying away some or all of their profit – or hedging over a longer period, but accepting more risk in the meantime.
In most manufacturing businesses, increasing raw materials costs would result in the price rising for the customer. So, on the face of it, swaps end-users should be paying a wider spread.
According to one trading head, very senior supervisors have been making this point in private – rather than complaining that regulation is making the business uneconomical, banks should start charging more.
So, why aren't they?
In most manufacturing businesses, increasing raw materials costs would result in the price rising for the customer
The banks put it down to competition, pressure from senior management to grow revenues, and the strategic drive to internalise more client flow rather than pay brokers to find a hedge. To put it more dramatically, if everyone is fighting for their lives – as individuals and institutions – it takes a brave trader to send business elsewhere.
"Everyone is in the mode of ‘We want to win market share, we need to see the flow, we're not prop trading as much, we need to be in front of the client'. And management is beating them up saying ‘We need to be up in the rankings'. So I don't think it's a natural instinct to widen bid-offers," says one fixed-income trading head.
An economist might see this as a collective action problem: if dealers could all agree to widen bid/offers by a minimum amount, and stick to it, decreased liquidity in interdealer swaps and futures would not be an issue.
But that won't happen, and it demonstrates how much competition exists in this peculiar oligopoly.