Icap launches reset risk competitor to Switchfix

Interest rate swap trading desks now have an alternative method of eliminating reset risk, courtesy of a new online matching system developed by Icap – the UK interdealer broker – called Fra-Cross.

The service aims to reduce reset risk caused by having swap positions with differing maturities. For example, a trader paying a five-year swap that then receives a five-year swap several days later at a more favourable interest rate cannot forget about the floating legs of the trades. There is a risk that interest rate volatility will cause adverse effects on the profit/loss profile of the portfolio due to rate changes between the two reset dates for the duration of the two swap deals.

Dealers say it is important for risk management to eliminate this risk, especially during high interest rate volatility. “When you have volatility in short-end rates, you don’t really want to be leaking P&L, simply because it’s not something you focus on. It’s not your core business,” says ABN Amro interest rate derivatives trading executive director Gary Hawkins.

Using forward rate agreements (FRAs) that are netted off against each other is one way to alleviate this problem – and already accounts for about 25% of all FRA trading at Icap.

Fra-Cross allows banks to enter all their relevant trading positions on a secure website. Icap then fixes yield curves for three- and six-month FRAs but gives dealers an opt-out if they do not agree with the curve. Once a ‘run’ starts, an optimising algorithm is used to offset as many FRA positions as possible. Customers are then e-mailed the results and charged about a quarter of a traditional broker’s fee.

The online system, which allows direct input through Excel spreadsheets, should be able to easily handle trades with up to 30 to 40 legs, well in advance of a traditional voice broker that struggles to handle more than three or four, says Icap electronic broking division marketing manager Charles Sabel. Fra-Cross covers sterling and euro swaps, and will offer dollar and yen swaps within about a month.“Fra-Cross is covering a whole lot of risk that traditionally swap houses haven’t really focused on. If you are running a medium-term swap book, are you really worried about the day-to-day movements in your fixes? The answer is ‘probably not’. Effectively, it’s a fairly efficient way to manage that short-end basis risk,” says ABN Amro’s Hawkins.

Matching-off reset risk is a relatively new phenomenon, but Icap is not the first to market. Rival interdealer broker Tradition set up an e-mail service called Switchfix more than two years ago, says Switchfix marketing director Mark Weingard. Switchfix is used at about 90% of financial institutions in the rates business, although there are notable exceptions, including Goldman Sachs. It covers nine currencies, with three additions – South Korean won, Canadian dollar and Brazilian real – now under review.

Its lead time gives Switchfix a key competitive advantage. “You need to have a large liquidity pool, otherwise nothing happens,” says Weingard. He says adding another two banks to a run with 10 initial banks could boost liquidity by 50%. Switchfix runs more than 2,000 trades a month. Icap’s Sabel counters that the firm’s large client base and market confidence in its curves will help it gain a foothold. “There is room for two in this market,” he adds. Fra-Cross’s first bi-weekly sterling run had 22 users and saw 105 trades worth £7 billion – not as much as Switchfix, but Sabel believes a respectable start. Sabel also believes Icap’s minimum trade amount – about one-fifth of Switchfix’s – at least in the sterling and euro markets, should also prove an advantage.

Dealers say charges for the two services are relatively similar, and most planned to use both systems in the near-term at least. Charges depend on the number of trades executed, with banks paying between $100 to $40,000 a month.

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