In theory, it would appear a fairly logical proposition given that interest rate swaps are the most widely held single product type among all over-the-counter (OTC) derivatives (around 55 per cent of total notional outstandings worldwide). The salutary lesson of Blackbird, an electronic-only, inter-dealer trading platform that went live in September 1999, shows that despite possessing the best technology, keeping interested parties onside is paramount.
Advocates of electronic trading platforms claim that electronic swap-trading offers several advantages over the traditional (voice) swap markets. Increased market transparency can arise through multi-dealer platforms acting as anonymous liquidity aggregators, thereby allowing for fuller view of the market while tightening spreads. While exact brokerage fees can be something of a moving target, most firms say they can offer tariffs that are up to 50 per cent below what is charged by voice brokers - and in some cases it is significantly more.
Competitive advantages
Though interest rate swaps are fairly complex and innovative financing arrangements, banks, investment firms and corporate finance departments are able to exchange (swap) interest payments on floating-rate debt for interest payments on fixed-rate debt in the same currency, or cross currencies for hedging long-term currency risk. By doing so, organisations can control interest payments, manage debt, and enhance their portfolios, with the two parties involved agreeing to make periodic payments to each other for a specific length of time based on specific interest rates on an agreed-upon ‘notional’ amount.
The global interest rate swaps market has certainly experienced significant growth in recent years. Data compiled by the International Swaps and Derivatives Association (ISDA) and the Bank for International Settlements (BIS) revealed that the total notional outstandings reached approximately $127,000bn in June 2004 – up from $36,000bn in 1998, while average daily swaps trade volumes rose almost fourfold to $611bn during the same period. But globally, the swaps market (plain vanilla swaps, overnight index swaps, exotics) sees perhaps 3,500 daily trades.
Highlighting the low level of trading of IRS on electronic swap platforms, a report published last September by Celent Communications entitled Swaps: Has The Time Come for Electronic Trading?, indicated that approximately 2.5 per cent of all interest rate swaps were traded electronically, with EONIAs (European Overnight Index Average swaps) and US dollar Overnight index swaps being the most liquid segment of the market and showing a healthy migration to an electronic trading model.
The research points out that 10-12 per cent of the EONIA market – short-dated maturities of (1-2 years) are now traded electronically, but forecast to grow to 35 per cent by year-end 2006. Less than 5 per cent of all medium- and long-term interest rate swaps will be traded electronically by the end of 2006, the research says, with a lack of product standardisation and credit management issues affecting progress.
Electronic trading of IRS can certainly help improve automation in trading, deal processing (STP) and alleviate the potential for human error. Stephane Rio, chief executive officer of Swapstream, the only multilateral electronic trading platform for medium- and long-term interest swaps (up to 50 years maturity), commenting on the increasing interest in IRS trading, says: “We are now reaching a level where – if not the trader – at least the back office part will not be able to handle it so easily. This is a level where the volume you are dealing with either becomes too high or too expensive to perform along a traditional voice and paper-organised way. With the creation of LCH SwapClear to clear plain vanilla swaps, and SwapsWire, which established an automatic confirmation layer, the last part of the equation is electronic trading. So, once you have traded electronically your loop is closed, after which everything else should proceed smoothly.”
Success story
The success of SwapsWire, a London-based operation that was backed by a consortium of 10 leading derivatives trading firms in 2000, provides added scope for handling growing trade volumes of IRS from both traditional and electronic routes. Envisaged as a ‘one-stop-shop’ for electronic swaps executions, a remodelled platform was rolled out in October 2002 as a trade confirmation and back office only processing system. It subsequently attracted around 70 dealing desks in the US, Europe and Asia, with customers being the major inter-dealer brokers, swap trading institutions and buy side firms.
The system allows users to confirm and process transactions for inter-dealer brokered trades, direct dealer-to-dealer (buy-side) trades. Once a trade has been executed, a broker can input transaction details into SwapsWire through a desktop interface or by a direct link from the broker’s internal trading system.
In the ‘inter-dealer’ market space, trading platforms include i-Swap, owned by the world’s largest inter-dealer broker ICAP, as well as independents such as ATFox and e-Mider. Last September, ICAP successfully launched electronic trading of EONIA on the i-Swap platform, with the system achieving an average of €3.9bn 1MEQ1 per day in the first four weeks.
The i-Swap system offers a screen view of liquidity in euro interest rate swaps. In EONIA it offers external market display, counter party credit checking, implied strategy trading, voice and electronic liquidity and straight through connectivity to the banks’ back office systems. While i-Swap began with EONIA market for electronic trading, it will be launching in this autumn (Q4) medium-term euro swaps, a much larger market than the EONIA market.
Kieron Nolan, development director for i-Swap, commenting on the functionality of the platform, says: “Given that a high percentage of trading in the derivatives markets are linked orders where participants are trading yield curve spreads and strategy trades within the swap market, probably the most important piece of platform functionality is that i-Swap can perform this kind of trading at extremely high speeds and legs strategy orders into their outright markets.
Nolan: offering tighter bid/offer spreads
“If someone wants to do a five-year against a 10-year euro spread, you can either trade that spread but also trade the two constituent spreads. For a given order book we can generate a tighter bid/offer spread and more trades than any other system out there.” As of June, there were 21 users of the i-Swap platform, which also incorporates voice broking.
In the ‘multi-dealer-to-client’ (B2C) market, where dealer banks either populate platforms with competing bids against which clients can deal either directly, or interact via an ‘RFQ’ (request for quote) model, the players include Bloomberg, Thomson TradeWeb, Reuters’ Matching for Interest Rates, Swapstream is the only company operating in the interbank/broker segment (B2B).
Mr Rio, reflecting on market’s dynamic and growth, says: “There is clearly potential growth on the short-term business (EONIA’s) as it is very liquid and there is little in the way of credit involved. Yet, if you talk to the banks about where their key interest lies today, the focus has shifted, and lately there has been increasing market interest on what is happening at the long end rather than at the short end.”
“If you look at the B2C business (dealer to client) segment, when TradeWeb and Bloomberg launched their products, participants were discussing less about the one-year or EONIA products traded on these platforms but more the 10-year interest rate swaps. And, that is what is driving the business of the banks and this is where Swapstream is positioned today.”
Tailoring transactions
As recently as 13 June Lehman Brothers joined TradeWeb’s Euro IRS platform as a liquidity provider. TradeWeb at the same time announced that its IRS platform has been expanded significantly to offer forward starting interest rate swaps and off-benchmark swaps. Using TradeWeb Swaps ‘RFQ’ model, institutional investors can now tailor their transaction beyond plain vanilla swaps to incorporate specific termination dates and other parameters. The extended trading platform is the only one of its kind to be fully integrated with ISDA confirmation functionality, providing further efficiencies to the buy and sell-side.
Barclays’ BARX platform on Bloomberg fills the ‘single-dealer’ platform space, although other dealers such as Morgan Stanley have made their entrance. On 11 October 2004, it was announced that Morgan Stanley was augmenting its e-trading services with the addition of IRS via the Bloomberg terminal.
To further illustrate how the various platforms are seeking to differentiate themselves, Swapstream positions itself as a neutral service provider allowing it to act as a facilitator without ever competing with banks or brokers. In November 2004 it launched futures crossing functionality to its market platform. By means of a link with Eurex, the world’s leading futures and options market for euro-denominated derivative instruments, Swapstream became the first platform to introduce futures crossing in the electronic IRS industry, enabling its members to execute IRS swap orders with a fully automated futures cross (Bund, Bobl or Schatz) as a package via a couple of clicks.
This yields benefits in terms of lower cost and critically reduces risk as two related transactions (IRS swap and futures cross) do not have to be undertaken separately. The Swapstream service is delivered over a secure private network from Deutsche Börse facilities in Frankfurt and provides reliability in terms of application hosting and disaster recovery.
Today, the company says the platform has over 30 banks and brokers accessing and providing liquidity. And, through its Userboard market participants regularly offer feedback through to Swapstream, which is key to shaping future enhancements.
While it might be too early speak of full take-off in the electronic trading interest rate swaps space, the industry certainly seems to have learned some hard lessons. By responding to market and user needs and enhancing platform functionality the portents are set fair. As with algorithmic trading, one should keep a close eye on future developments.
