Instant anguish

Risk’s inter-dealer rankings, published in this issue, are meant to reflect the market’s considered opinion on which firms are best at providing liquidity, service and prices in a wide range of derivatives product categories.

But there are times when it would be interesting to be able to do ‘instant polls’ – much like those featured on US evening news programmes. If we had the technology (and traders and end-users had the patience), we would reach out and capture the market’s sentiment at a moment’s notice. We might get some interesting results.

For example, which interest rate swaps dealer proved its mettle on July 31 and August 1? One might imagine that none of the firms in this increasingly concentrated market would get high scores from end-users, based on the way spreads widened sharply on those two days, reflecting how the market’s liquidity evaporated under stress.

Spreads came back in over the course of the following days and weeks, but the episode’s lesson is not easily dismissed: the interest rate swaps market, notionally the largest and presumably the most liquid derivatives market in the world, is very dependent on just a handful of firms.

Perhaps the spate of e-trading initiatives (the Barclays Capital/Bloomberg system, Icap’s and Cantor’s offerings, and Swapstream, among others) will help by providing more transparency and possibly more liquidity for the interest rate swaps market. Barclays says its system – launched in late July – weathered the worst of the market volatility without any long outages, but some of its competitors say it was forced offline for significant stretches. In any case, the success of any electronic platform depends on the willingness of the dealers that back it to continue to do so when times get tough.

Given the monstrous size of the US mortgage market – nearly $5 trillion, according to some estimates – compared with the roughly $3.5 trillion US Treasury market, it’s difficult to imagine that convexity hedging-driven periods of market stress will not become relatively common features as interest rates rise.

Indeed, the markets’ anguish over the increase in interest rates since mid-June is somewhat surprising, since the rates had hit 40-year lows – there wasn’t a lot of room for them to decline further, especially on the short end. The US economy had to begin shaking off its lethargy eventually. Any sign of an improvement in the US economy (or ill-advised official comment on the relative threat of deflation versus inflation) was bound to start medium- and long-term rates marching upward.

So was everyone caught off guard – as it appeared – or is it simply too difficult for most dealers to consistently run a rate book in a volatile market, a market where mortgage-hedging technicals can turn a modest correction into a meltdown? If the latter, we could see even more concentration in the swaps market.