When automated market-making meets an already liquid market backed by real money trades, arbitrage opportunities quickly follow, which is the direction most liquid portions of the swaps market are moving. Even in this pre-regulation implementation time that continues to linger, adoption of electronic trading is finally starting to gain momentum. Data from Bloomberg, CreditEx and Tradeweb in just the past months show a sharp increase of on-screen execution and despite continued lobbying relating to specific details of each regulatory proposal, the market, by and large, has accepted that the swaps market is going to move to into the electronic age … finally.
For some trading desks, this means spreads will tighten and profits (in the near term) will decline. It is true that spreads in liquid markets such as 10-year interest-rate swaps and index CDS are already tight and some people argue that because of this, there isn’t much profit at risk if spreads tighten further. But if you consider a quarter basis point decline from one-half basis point to one-quarter basis point, that equals billions of dollars in a market that measures its yearly gross turnover in quadrillions.
Fortunately, there’s no reason to fret because both existing and new swaps dealers will continue to make plenty of money. The old adage that it takes money to make money is undoubtedly true here. Changes necessary comply and compete will be costly; a business model that has stood still for nearly 20 years must be recreated and an infrastructure that was designed for weekend batch jobs must be transformed into one that can handle real-time clearing and intraday margin calculations. But once all is said and done, the new opportunities are enormous as a whole world exists, full of untapped trading potential.
The most exciting opportunities exist for firms that are already playing a part in trading the futures and cash fixed income markets electronically. Swaps dealers, principal trading groups and some hedge funds fit the bill. Arbitrage opportunities between swaps, bonds, futures and even FX will quickly emerge as electronic access allows development of automated strategies that before were never possible.
US government debt products are some of the most liquid in the world. Products such as Eurodollar futures and US Treasury futures are both heavily traded and have valuations that are highly correlated to US government debt. Basis trading between these products exists today. Add in interest rate swaps, which can be synthesized using futures and are closely aligned with US debt, and the arbitrage opportunities become clear. Correlations between interest rate and credit products, which throw credit default swaps (CDS) and corporate bonds into the mix, are also compelling trading propositions.
The primary focus will be on relative value trades, i.e., looking for theoretical price difference between two similar structures. For example, a strip of Eurodollar futures could be traded simultaneously with a 5-year interest rate swap when the price of the former isn’t in line with the price of the latter, taking into account convexity bias and differences between swaps and futures.
Statistical arbitrage will exist in the new swaps market but will be slower to develop because historical data that is detailed enough to help determine trading signals and develop automated trading strategies is nearly non-existent. Not until trading, clearing and reporting mandates are all in place will sufficient market and trade data be generated and publically available to make statistical arbitrage trading accessible to most trading firms.
Ironically, creating the trading strategies is seen as the easy part. Several TABB Group conversations with automated trading firms have confirmed that creating algorithms to automatically trade swaps is not much of a stretch. The proposed strategies are not much different than those used for related exchanged-traded products today, and so adopting those algorithms to work in the new swaps market is manageable work. However, creating an infrastructure to gather, consume and disseminate the required data is not an easy task.
Swap execution facilities (SEFs) are also set to gain from these changes, operating as some hybrid of exchange and agency broker, making money not on the direction of the market but on the total volume they process, and automated trading is good for volumes. An upcoming TABB Group study for which two dozen swaps dealers were interviewed shows further potential for SEFs that offer trading in other products. Nearly 80% of swaps dealers believed that those SEFs with an already liquid cash market, whether in US Treasuries or corporate bonds, would have an advantage in gaining swaps liquidity. The ability to execute the aforementioned relative value trades on a single platform is apparently appealing.
Whoever ultimately wins or loses, more automated, relative-value trading can only improve pricing amongst these related fixed-income instruments, leaving the market more efficient for end users and real money accounts. Top-tier dealers will not have smaller trading desks, but desks with a few more computer scientists and a few less MBAs.
We’ve been down this road before.
But this time we can build the new market structure with the benefit of hindsight.