The success of electronic swaps trading on Barx, Barclays Capital’s dealer-client fixed-income platform, since its joint launch with Bloomberg in July 2003, has driven interest in trading in the inter-dealer space. In an address to the Bond Market Association on December 8, Icap’s chief executive, Michael Spencer, said the Barclays initiative “has proved to be visionary” and has “probably shifted the consensus” on the feasibility of electronic swaps trading. “I am convinced the time has come for the swap market to go electronic, and we at Icap intend to be at the forefront,” he added.
It is not the first time a pure electronic player such as Swapstream has moved to capture the inter-dealer euro swaps market. Other inter-dealer platforms include Icor, Blackbird, MTS/ATFox and Icap’s own iSwap. All will have to overcome some degree of scepticism from the largest liquidity providers, though many of Swapstream’s existing users believe it is well placed to take advantage of electronic trading when (or if) it takes off.
Depending on the duration of the swap contract, Bund, Bobl or Schatz benchmark futures can now be crossed or fixed on the Swapstream platform and executed automatically when the swap is traded, eliminating the need for counterparties to finalise a swap deal through a futures broker. Through Eurex, a futures and options market for euro-denominated derivatives, Swapstream is the first platform to offer this facility.
Crossing futures in a euro swap trade has become a standard practice in the past two years, with up to two thirds of swap flow being referenced against a futures cross.
Peter Millington, head of swaps and bond trading at Banco Santander Central Hispano in Madrid, believes the Swapstream offering marks a positive step forward for the electronic market. “Having an electronic futures cross capability is the most efficient way for a market maker to turn around his risk,” he says.
But others disagree. A managing director at a large US investment bank believes dealers take the easy option too readily. “Maybe some of the traders aren’t as capable as they used to be,” he says.
Stéphane Rio, chief executive of Swapstream, believes futures crossing will significantly reduce the workload for existing users, and hopes it will be instrumental in attracting new ones. “With our platform, data will be sent immediately to the futures broker for execution,” he says. “No further action is needed from users.” Moreover, he stresses that it is a user-neutral platform, which means brokers can also use it, though they would have to pay Swapstream for the privilege.
It is unlikely, however, that Icap will sign up to the platform. As well as not wanting to pay a third party for an
e-solution to a broking service in which it dominates, it launched its in-house electronic offering, iSwap, in September 2004 in the short-dated, euro overnight index average (Eonia) market. Icap claims daily volume averaged e3.9 billion in the four weeks to November 23.
With medium- and long-term swaps (that is, two years and longer), actual trading continues to be executed with voice brokers, with the iSwap platform complementing the service as an information tool, making Icap’s swap service a hybrid offering. If Swapstream is to make inroads in the euro swaps market it will have to do so at the expense of Icap.
David Casterton, managing director at Icap, does not believe there is sufficient interest yet from market participants for an electronic-only solution. He says his firm continues to monitor developments in the electronic market closely, but he does not believe its market share is under threat. “It’s very important in the inter-dealer space to have the voice capability to run alongside a platform. It adds colour and we also have a liquidity pool,” he says. “Our market share is steady, at least at 40%.”
Rio, previously a head trader at Commerzbank, acknowledges that the most difficult task for any newcomer to a market dominated by an incumbent broker is to attract a critical mass of users, particularly market-makers, required to reach an adequate level of liquidity. But he believes Swapstream will soon have the critical mass needed.
He points to the London International Financial Futures and Options Exchange (Liffe) going electronic in 1998 as proof that market participants can adapt to new technologies when there is a significant benefit. “It took a few weeks to get used to it, but once it became familiar, there was no question of going back,” he says. And he hopes the same will be true for the euro swaps market. “Instead of having someone filter market information to you, here you have it all in front of you. It is optimal and efficient.”
This may be the case, but while listed derivatives and wholesale foreign-exchange and fixed-income markets have gone electronic, over-the-counter derivatives, of which interest rate swaps are a prominent segment, have largely continued to be voice-brokered. Inter-dealer credit default swaps (CDS) trading has seen some migration to electronic platforms, most notably Creditex’s considerable success in tapping the iBoxx (now DJ iTraxx) index market in February 2004, but it remains to be seen whether rates or even single-name CDSs will see similar trends.
Traders express mixed views about Swapstream’s offering and about inter-dealer electronic trading generally. Some point to a “radical” change in electronic fee structures compared with traditional voice brokers, and praise the straight-through processing of the futures cross function. Others think Icap’s market power and liquidity will make its franchise too difficult to break, and point out that it could simply activate the iSwap platform in the medium and long end of the curve, even if it does not have the functionality of Swapstream.
Jan Kloosterboers, head of euro swaps trading at ABN Amro in Amsterdam, says Swapstream “has the best functionality of any platform at the moment”, and believes it is “inevitable that swaps will go electronic”. Banco Santander’s Millington points to the charging regimes: “With brokers, the fee is related to the duration and size of ticket, whereas electronic charges a per-ticket fee.”
With the bid/offer spreads squeezed even further, the fee has become far more significant. “Typical brokerage fees range from around 1/20 basis points to 1/8bp for smaller counterparties, which is a significant part of a bid/offer in a swap,” Millington adds.
A trader at Dresdner Kleinwort Wasserstein, one of the members of the platform, is more sceptical, and points out that Icap can respond by either switching on its existing platform or squeezing its brokerage fees further. He also says electronic platforms have thus far encountered technical limitations. “We do a small fraction of business through Swapstream. It needs to sort out some technical issues and the liquidity is not significant on it yet,” the trader says.
The liquidity issue is crucial, although opinions again vary on the degree of liquidity in the electronic market. Millington says it is a “matter of time” before liquidity migrates to Swapstream’s platform, while Josef Eckl, head trader at HypoVereinsbank in Munich, one of the market-makers, does not think it is a problem.
What distinguishes interest rate swaps trading from, say, CDSs is the prominence of curve trading in rates. The CDS market consists of bid/offer spreads of a given list of individual credits, usually of five-year duration (which may nonetheless be correlated). Different rates traders might submit prices on, say, an outright two-year swap, an outright five-year swap, a five-year/10-year spread and a two-year/five-year/10-year butterfly, all of which can be traded together in one large curve trade by a broker.
There is a whole chain of deals here where outright and spread orders generate implied prices, each driven by dealers’ individual needs. Tailoring an electronic solution to this is somewhat more complicated than an outright vanilla market of independent entities.
A senior trader at a prominent European bank believes electronic trading cannot work in the inter-dealer swaps market, where he believes the human
element is critical for establishing the mid-market level. “The value of the information you can get from someone over the phone is significantly greater. The ability to trade at mid-market level is critical for a swaps dealer and that can only really be done by voice,” he says, especially in more volatile conditions. He believes e-trading cannot match voice broking when the curve moves, during which changing the inputs electronically is “not proficient” and cumbersome.
The challenge for any new entrant is not only through its technological innovation and user-friendliness. Even were these factors addressed satisfactorily, persuading enough liquidity providers to back a platform is tough.
The same managing director of the US investment bank who is disparaging of today’s traders does not believe Icap’s position is under threat, but feels there is always space for new players in the market. “We’ve been looking for a credible second broker for a while. The opportunity is there for somebody to emerge,” he says. “I just go for where the main liquidity is. If it is electronic, fine, I’ll go electronic.”