The current execution landscape for OTC derivatives is in for a rude awakening. Index CDS and the most liquid interest rate swaps (2-, 5-, 7- and 10-year) are set to move into a world of high speed messaging and even higher speed analytics. Many have already discussed how an expected execution mandate for OTC derivative products will cut spreads and subsequently dealer profits, but the extent to which the landscape will change has been underestimated.
There is no technological reason why these products cannot trade in continuous two-sided markets. Compute power and density are unprecedented. Sixty-four core servers, several hundred core GPUs and FPGA implementations can process data in nanoseconds. And a gaggle of the best, brightest computer scientists, mathematicians, physicists and network engineers make the idea of creating a high speed quoting engine and corresponding matching engine look like a walk in the park.
These scientists are the same people who worked for Google and NASA but migrated to the world of high finance, attracted by new challenges and seven-figure salaries.
In fact, TABB Group has had numerous conversations this year with several of these little known technology and trading firms (most often one in the same), sitting on the sidelines, building intellectual property and improving systems, waiting for the fateful day when OTC derivative-reform legislation and corresponding regulations are finalized.
In other words, technology now exists to transform this market. This is fact, not speculation.
Unfortunately, until now, culture has thwarted technology. Keeping the current state of politics out of this for a second, economic incentive is requisite to drive change and for the largest players in OTC derivative trading very little direct incentive exists. Electronic trading tightens spreads and lowers barriers to entry, two realities market makers do not want to occur because it would force a complete reworking of their business model – a business model proven profitable.
Politics, namely OTC derivative reform will usurp economic incentive as the catalyst for change. It’s quite simple actually. Until now, dealers wanted to trade with each other and so needed to know who was on the other side of every execution. This is sensible as counterparty risk is a huge concern when trading bilaterally. Centrally clearing will change that. With a clearinghouse sitting between each trade, execution can be done anonymously as counterparty risk is reduced to almost zero. This is a significant change because it will permit those waiting-in-the-wings trading firms to offer electronic liquidity in what is now a dealer-to-dealer market. It will also allow inter-dealer brokers, nervous to alienate their biggest dealer clients, to accept liquidity from the new electronic liquidity providers.
Capital to back these new ventures is not an issue. Capital may be scarce for dealers, but not for the market’s soon-to-be-minted liquidity providers. These firms are technology heavy and do not have the legacy infrastructure to support, nor do they need to be members of a clearinghouse, which requires considerable capital, as they can outsource that business to the dealers. Furthermore, newly employed market-making strategies may leave positions flat at the end of the day, so little collateral will need to be posted. As for the IDB soon-to-be SEF community, since they are trading purely on an agency basis, taking no proprietary risk, capital is not an issue for them either.
It is important to point out that this move is not a move to “exchange trading” but a move to electronic trading. In fact, TABB Group believes that it is the inter-dealer broker community, along with a few non-broker platform providers, who will become the liquidity sources for OTC derivatives, not the exchanges who will experience more success in clearing. Big names like the CME, NYSE Euronext and Eurex can never be counted out completely, but trading swaps is what the IDB community does and the process does not translate well into a listed-exchange model.
Technology is idling, ready to go. Trading strategies have been developed. Legislation is moving down a path to the White House. All signs point to a fundamental change in the way vanilla OTC swaps are traded, one that will rival the transition from the specialist booth to today’s matching engine. Voice trading will continue to exist and thrive, even for these vanilla products, serving only as a value-added service to the liquidity seen on the screen.
To underestimate the scope of this change is to be left behind. Hedge funds, proprietary trading firms, inter-dealer brokers, technology providers and quite possibly small teams at the major dealers see what’s coming.
It’s time to jump on the bandwagon.