Icap’s game plan for electronic survival
In the ferociously competitive world of inter-dealer derivatives broking, technology has become the critical weapon.
This was confirmed by Michael Spencer, group chief executive officer of Icap, the world’s number one derivatives broker, in his firm’s annual report for 2003. Not only can technology create opportunities but it is also a necessity if brokers are to stave off the threat of disintermediation by their customers.
“A key strategic opportunity for Icap is to create faster, more transparent, more efficient broking services using technology to constantly enlarge our available market, and make it more economic for banks to trade through us rather than direct,” said Spencer.
But technology is neither panacea nor quick fix. It is not simply a case of replacing all traditional broking with electronic trading. The secret of success in this environment, according to Icap, is to provide electronic platforms where there is a demand for them, and otherwise to bring technology as close to the voice trading activity as possible to improve efficiency and reduce costs... and to be ready when a market does decide to move. This hybrid model keeps the voice and electronic liquidity pools together.
The most important step in this direction that Icap has taken recently was its purchase of BrokerTec, a fixed-income securities electronic trading platform, in May. Combining BrokerTec’s electronic volumes, which were an average of $190 billion a day for the first quarter of 2003, with Icap’s mostly voice-broking volumes, has brought the firm’s total daily trading volume up to $550 billion a day, and increased the proportion of electronic trading to 40%.
Icap already had its own fixed-income electronic trading platform, called Electronic Trading Community (ETC), specialising in so-called off-the-run (non-benchmark) US Treasury bond swaps. This handled volumes of $14 billion a day. BrokerTec, meanwhile, focuses on on-the-run (benchmark) bonds, also known as actives, so the two platforms were complementary.
“A recent project, Cross Connect, has been completed to bring together both markets on the same screen,” says Dermot Doherty, director of marketing in Europe for BrokerTec, a part of Icap’s electronic broking division. “In the US, firms like to trade the actives electronically because of the liquidity and the post-trade [straight-through processing]. Having BrokerTec and ETC on the same screen brings together a large pool of potential clients.” The platform now has over 400 clients globally.
Using Cross Connect, the screen shows bids and offers on both markets, as well as how many offers or bids are made against a price – indicating the depth of the market, says Doherty. But while all users can look at the same integrated screen for US Treasury trading, Icap has had to recognise the different habits of those who trade the active US Treasury bonds and other product traders. Because of the speed of the actives market, traders prefer a keyboard to a mouse to input trades, and Icap now provides a specially developed simplified keyboard for the actives market participants. Icap also bears the cost of delivering the service to new clients, including the installation of the BrokerTec server and integration of it with the client’s IT infrastructure and connecting to the network – most existing clients have dedicated lines, although some smaller banks use the system via the internet.
“Every bank has its own technical environment, so the connectivity issue is different for each one,” says Doherty.
BrokerTec is built on a platform from Stockholm-based exchange and trading software supplier OM Technology, with a customised user interface. The system provides a window showing details of trades completed, and most users have a direct feed from the trading system into their position-keeping applications. This straight-through processing of transactions reduces operational risk and improves efficiency, says Doherty. Clients can still choose to trade the market through Icap’s voice-broking division but will pay more. The company will not say what commissions are, but generally commissions on electronic trades are half those paid for voice-brokered trades.
Icap is expanding the coverage of the new combined BrokerTec/ETC platform, with US dollar-denominated supra-nationals and sovereigns introduced in November. Trading on the system for the majority of markets is anonymous, with clearing undertaken by London Clearing House or Clearnet in Europe and Fixed Income Clearing Corporation (formed from a merger of the Government Securities Clearing Corporation and the Mortgage Backed Securities Clearing Corporation in January this year) in the US, which also act as central counterparties.
While fixed-income trading moves steadily to the electronic world, interest rate swaps trading has remained stubbornly in the realm of voice broking. Although there have been a number of attempts to create electronic venues for these instruments, such as Blackbird and the consortia-based SwapsWire, none has proved successful so far. A number of factors account for this failure, says Kieron Nolan, director of I-Swap, an interest rate information platform developed by Icap’s electronic broking division. Some of the systems were poorly designed, attempting to replicate traditional brokerage but ending up offering only a poor alternative. “Computers are not good at ambiguity,” says Nolan. They could not offer satisfactory credit arrangements. “The [trading platform] has to be more complex than an exchange, where credit is managed by a central counterparty,” he says.
Also, the market was – and remains – ambivalent about electronic trading platforms for interest rate swaps. “Other than in the short-dated end of the market, the major banks are generally happy with the status quo,” he says. The result is that none of the platforms have attracted the liquidity necessary for success.
But this does not mean technology has no part to play in the interest rate swaps market, nor that the market will never migrate to electronic trading. So Icap’s strategy has been to create the I-Swap platform for price information dissemination and trade processing, but with built-in trading functionality that can be turned on at any point in the future should the market decide it wants it, says Nolan.
I-Swap is a customised version of the X-stream multi-instrument trading platform created by Sydney-based Computershare and already used by a number of equities and other exchanges. Taking this approach rather than building in-house from scratch saved development time and reduced project risk, says Nolan. The system is largely written in the C++ programming language, with the trading engine written in C for performance, says Nolan. It uses the FpML derivatives data standard for communicating confirmations and other information. Banks can either link directly to I-Swap or receive confirmations via SwapsWire, which has transformed itself into a trade-processing venue and which also uses FpML.
I-Swap offers “enhanced price dissemination and a screen view of liquidity that banks can download into spreadsheets or other trading applications,” says Nolan. Instead of the limited price information that can be shouted to customers down the telephone, I-Swap provides a constant flow of price changes, plus daily high, low and other historical prices, audit trails and other information. So far, I-Swap is live with customers for swaps, forward rate agreements (FRAs) and Euro OverNight Index Average (Eonia) deals in euros. It covers 1,000 instruments with 16,000 spreads. And although Icap’s brokers continue to quote and negotiate deals via the telephone, they now enter the orders on I-Swap from where they are handled in a straight-through processing environment.
Icap believes it is only a matter of time before at least part of the market will move to some higher degree of electronic trading, and plans to take the first step in this direction early next year.
“Around 95% of the interest rate swaps business is vanilla, and although the ticket sizes tend to be very large, the transaction volumes are low,” says Nolan. This is not the ideal basis for electronic trading, which better suits high-volume, lower-value transactions. “As other markets such as foreign exchange forwards and repos move to electronic trading, it will influence what happens with interest rate swaps,” he says. “In Eonia’s case, at the very short end of the swaps market where the number of transactions is higher, the installation of dealer entry on I-Swap has begun and is expected to launch in early 2004.”
As well as offering technology to underpin the major markets in which it is active, Icap also offers some technologies for more niche applications.
One of the consequences of an interest rate swap, where a fixed interest position is swapped for a floating interest one, is the need to hedge the floating interest leg against rate movements. A five-year swap, for example, will typically have 10 semi-annual resets, and these are usually hedged with FRAs. But trading these in the conventional way takes time and is costly. So Icap created an electronic platform called Fra-Cross, which offers a crossing system to periodically and automatically match participants’ resets.
Fra-Cross provides a screen where traders can enter all the positions they need to hedge, or they can upload them from an Excel spreadsheet. The trades must be priced against a yield curve, and Icap calculates a mid-price curve using futures with an adjustment for market sentiment.
“On the day of [the matching session] we speak to brokers who give us input on the curve, and we adjust it to match the market,” says Fra-Cross director Charles Sabel. “When we are happy with the curve we freeze it – usually about two hours before matching – so everyone knows the rate they are trading at. And if a trader doesn’t like the curve then they don’t trade on it.”
Should they decide to go ahead, participants can set matching criteria for their positions, such as not wishing to match over a month end or around a date when interest rates are due to be fixed by the central bank. They also allocate credit by assigning an amount available to each counterparty registered on the system.
Matching sessions are held for each currency – currently there are sessions for seven currencies, including the US dollar, sterling, the euro and the Swiss franc – every three weeks on a Monday, Tuesday or Wednesday at 4:30pm GMT. The results are posted on to the Fra-Cross website – brokerage fees are charged only on successful trades – and confirmation can also be emailed to participants for uploading to a spreadsheet, or transmitted via Swaps-Wire or directly to back-office systems for the straight-through processing of trades.
The web-user interface for Fra-Cross was built by MBA Systems, based in Hampshire, England, with the rest of the platform, including the matching algorithm, developed in-house. The platform now has 90 banks signed up and around 280 regular traders. Previously, these banks would have undertaken the trades manually. Fra-Cross is an efficient way of executing the trades and removing potential risk from a trading book with minimal effort, says Sabel.
BrokerTec, I-Swap and Fra-Ccross demonstrate how much technology plays a part in the inter-dealer broking world. But Icap does not believe electronic execution is about to take over all markets.
“Some markets, such as derivatives and the less liquid products, are likely to remain voice-broking domains for some time to come,” says David Casterton, managing director, Intercapital Europe, a division of Icap. “What our customers want now for many products are systems that deliver increased efficiency from electronic price discovery and straight-through processing – rather than electronic execution. It’s the application of well-designed electronic solutions and their successful integration with a negotiation-based voice service that will create the winning formula.”
Icap believes part of this winning formula is to increase the linkage between its systems so it can take advantage of its broad product range and liquidity in a number of markets to support interrelated trading across markets. “For several years, customers have traded the ‘spread’ between products, and increasingly they expect to make contingent trades that depend on the alignment of prices in several markets before deals can be completed,” said Spencer in Icap’s 2003 report. “We are developing and delivering technology to make these trades possible.”
|Credit downgrades on major banks|
|The central nervous system for Icap’s front-office operations is the MoneyLine Trading Room System (MTRS) market data distribution and integration platform from New York-based MoneyLine Telerate. This not only brings market prices to the traders, but also allows them to distribute prices calculated with their models to clients, to other desks or back out to the data vendors. |
On the desks, brokers make use of a variety of analytical applications. “We don’t dictate to the broker what they use,” says Lance Fisher, IT director for Europe and Asia at Icap. “Brokers select the applications they require, and some desks like to have more than one application because it gives them resilience.”
There is widespread use among the desks at Icap of the Kalahari Advanced Calculation Environment (Kace), a generic pricing application supplied by Kalahari, based in Surrey, England, and which includes a library of 1,600 pricing models developed by Kalahari and FinancialCad, based in British Columbia, Canada. In addition to the packaged models, brokers can call in Kalahari’s financial and software engineers to develop bespoke models for them.
Icap front desks in London, Hong Kong, Sydney and elsewhere now use Kace and its models, while the New York office is currently evaluating it. But the Kalahari models are not simply adopted as a matter of course – they have to compete with other suppliers, such as London-based AFA Systems’ Dart pricing and risk management applications – the origins of which lie in Icap itself. In the 1990s, the internal analytical software development group within what was then Intercapital (which merged with Garban in 1999 to become Icap) was spun out as a software subsidiary called Data Analysis Risk Technology (Dart). It was sold to AFA at the time of the merger, and continues to supply Icap with some models and applications.
But brokers’ individualistic taste in pricing software can prove a nightmare for a firm trying to control its IT infrastructure, because of issues of maintenance, security and so on. Icap therefore recently brought in a desktop application control package called Altiris Client Management Suite from Utah-based Altiris, which imposes some order on the way brokers implement their analytical tools. “Now people can’t just load their own software – Altiris locks down the desktop, and all applications conform to our security policy and business continuity planning,” says Fisher.
Once trades are done in the front office, they are fed through to one of two back-office systems. Matched principal trades, where Icap is in the middle between two trading principals, are processed in the Market Settlement system from London-based Misys Securities Trading Systems, while name give-up trades, where there is no clearing house and Icap acts as introducer between counterparties, are processed in an in-house developed system called Graphical User Interface Back Office System (Guibos). Core financial applications, such as accounting, are handled by Oracle Financials from California-based software giant Oracle.
Because Icap is an inter-dealer broker that does not take positions itself, it has no need of a risk or position management system such as would be found at its bank clients.
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