Here I talk with TABB Group Senior Analyst Paul Rowady about our new study looking into prop trading firms entering the swaps business. The report was also covered well by the folks over at Dow Jones – see that story here.
Principal Trading Groups (PTGs) Set to Act as Market Makers for Interest Rate and Credit Default Swaps, Says TABB
Clearing Access and ‘Click-to-Trade’ Will Make or Break PTG Swaps Market Entry Following Dodd-Frank Reform Rules Implementation
NEW YORK & LONDON, July 19 2011 – Financial regulatory reform efforts covering over-the-counter (OTC) derivatives are setting the stage for long overdue market innovation. In new research published today, “Higher Frequency Swaps Trading: Marketing Making and Arbitrage,” TABB Group says that principal trading groups (PTGs) – firms that flourish in highly liquid, highly electronic markets – are set to act as market makers for interest rate swaps (IRS) and credit default swaps (CDS).
Although statistical arbitrage will exist in the new swaps market, it will be slower to develop. “Arbitrage trading strategies, however, will follow quickly when automated market-making meets an already liquid market backed by real money trades, with the more exciting opportunities for those firms playing a part in the futures and cash markets,” writes Kevin McPartland, a TABB principal, director of fixed income research and author of the new report. He says that “Trading, clearing and reporting mandates need to be in place so that market and trade data can be generated sufficiently and available publicly to make stat arb trading accessible to most PTGs.”
Despite the near certainty that swap execution facility (SEF) trading and central clearing will be mandated for at least the most vanilla products, operational complexities of that model are still unresolved, he explains. “Unsolved and nuanced details of proposed rules could still leave barriers to entry excessively high.” He adds it is fundamentally essential that PTGs looking to enter the swaps business need access to clearing, which makes it easier to trade in and out of a position quickly and eliminates the requirement that all trading counterparties have AAA credit ratings. Clearing also allows SEFs to operate with anonymous executions. According to McPartland, “if ‘click’ doesn’t equal ‘trade’ and bilateral agreements are still required of both counterparties, the PTGs’ entrance into these markets would be crippled, if not altogether killed.”
The report goes on to discuss why these conditions are critical to PTG strategies and explains why TABB sees PTGs driving nearly one third of trading volume in OTC energy swaps markets, but not in other swaps markets.
Given the realities of the political world, the financial markets will probably not see full implementation of OTC derivatives reform rules wrap-up until at least 2013. “The groundwork, however, is set and there’s no turning back,” says McPartland. “The pre-SEF era is upon us and electronic swaps trading will see slow growth over the coming months.”
They key to opening the door for PTGs and dozens of firms looking to trade swaps is centered on access to clearing, and no matter what happens in the regulators’ conference rooms in Washington and Brussels, TABB believes that PTGs will enhance liquidity in this marketplace as they have elsewhere. “The only question,” McPartland says, “is, by how much?”
The 18-page research report with 6 exhibits is available for download by TABB Group Research Alliance Derivatives clients and pre-qualified media at https://www.tabbgroup.com/Login.aspx. For an executive summary or to purchase the report, visit http://www.tabbgroup.com or write to info@tabbgroup.com.
About TABB Group
TABB Group is the financial industry’s only strategic advisory and research firm focused solely on capital markets. Founded in 2003 and based on the proven interview-based research methodology of “first-person knowledge” developed by founder Larry Tabb, TABB Group analyzes and quantifies the investing value chain from the fiduciary, investment manager, broker, exchange and custodian, helping senior business leaders gain a truer understanding of financial markets issues. For more information, visit www.tabbgroup.com. In January 2010, TABB Group launched TabbFORUM, the online community currently with more than 8,000 capital markets members, drawn from buy-side and sell-side firms, exchanges, regulatory agencies, academia, consultants, vendors and media, focusing on issues covering current industry-wide topics.
FT Alphaville picked up on the video we posted at TabbFORUM (ahead of our official press release tomorrow, July 19) regarding my new study on the entrance of prop trading firms into the fixed income swaps markets. Despite the fact that reading your own voice transcribed verbatim is a little painful, the FT does a good job discussing one of the study points I found most interesting – that prop trading firms account for nearly a third of trading in the OTC energy swaps market. If you’re a client of TABB Group, please read the study for more details. If not, keep an eye on KOTS (Kevin on the Street) and TabbFORUM for more details in the next few days.
Read the full FT Alphaville story here.
It Takes Energy – HFT in the Energy Market
The presence of principal trading groups (PTGs) in the exchange-traded derivatives market, and their absence in the
credit and rate swaps markets, are both the cause and effect of turnover frequencies.
TABB Group estimates that proprietary trading (including bank proprietary trading) accounts for 55 percent of futures trading by contract volume and 41 percent of U.S. Treasury (UST) trading by notional. The electronification of these markets increased turnover frequency enough to encourage PTGs to enter, which in turn increased turnover frequency and ultimately liquidity, which led to more entrants in the field, and so on.
Contrary to popular belief, PTGs are not new to the swaps market. Although equities and exchange-traded derivatives made them famous, PTGs play a huge role in the cleared OTC energy swaps market. Although their presence took a hit following the credit crisis and the decline in oil prices, they still drive nearly a third of the volume on ICE’s OTC energy platform.
As with the push for central clearing of fixed-income swaps, the move to central clearing for energy came from an economic catastrophe. Post-Enron, counterparty risk and transparency were huge concerns in the energy market, which ultimately resulted in the establishment of ICE OTC and CME’s ClearPort.
PTGs came into the market around 2005 and quickly picked up market share. For those intimate with the details, the energy swaps market is the prime example of how an OTC-traded, cleared market should work: Two main clearinghouses exist in CME and ICE. Each carries similar contracts in natural gas, crude oil, etc. Those swaps can be traded virtually anywhere: over the phone, via an interdealer broker platform like GFI’s EnergyMatch® or ICAP’s ICAPture®, or via platforms owned by the exchanges.
Once executed, the trades are sent directly to the clearinghouse. Contracts are not fungible — meaning you cannot net a CME natural gas swap with one from ICE. Many larger brokers, though, provide services to essentially move positions from one clearinghouse to the other through a quick buy and sell.
PTGs entered the energy markets as market makers.As liquidity developed they made the move to arbitrage trading. The positive end result has been that spot, futures and swap prices in the most liquid energy markets remain in line with one another as arbitragers performing basis trades keep prices tight. The same progression is on the way for fixed-income markets. Market making will lead to arbitrage trading and ultimately to more efficiently priced markets.