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 The year-old trading venue, trueEX Group LLC, surprised many on Wall
Street when it had nearly 20 percent of the trades in
exchange-traded interest rate swaps in the U.S. for the week ending
Feb. 20. Though it has not matched those numbers since, its 9
percent market share so far this year marks significant inroads for
a startup vying against rivals backed by the most powerful banks,
investors and traders said.
Interest-rate swaps allow investors, companies, and banks to hedge
risk against future interest rate movements, and to bet on those
movements. They are the most common type of derivative, usually
involving a party who is paying a floating interest rate, swapping
that payment for a more predictable fixed interest rate with another
party, sometimes over the course of many years.
Many of the top derivatives dealers, including Goldman Sachs,
Deutsche Bank, Citigroup, Barclays, Bank of America Corp, and Morgan
Stanley, have declined to use trueEX. Other new exchanges have also
struggled to get traction with major banks.
The banks declined to comment publicly for this article.
TrueEX offers trading features, such as anonymous trading, that
regulators and traders at funds say will encourage smaller banks and
other players, such as hedge funds, to enter the market as dealers.
That will help increase competition, reduce prices for customers,
and decrease risk in derivatives markets, these people said.
Until now, a handful of too-big-to-fail banks have dominated the
market, potentially raising the risks that the failure of one party
could send major shocks through the financial system, analysts said.
The exception among the big banks is JPMorgan Chase & Co, one of the
world's top swaps dealing banks, which has joined trueEX, along with
12 smaller banks. JPMorgan also declined to comment.
If trueEX continues to build market share it could hack away at the
substantial profits the top banks can currently make from
derivatives trading. The top banks combined make $3 billion-$4
billion a year dealing U.S. dollar interest rate swaps on
exchange-like platforms, similar to trueEX's, according to Will
Rhode, Head of Capital Markets Research at the Boston Consulting
Group.
In other derivatives markets, banks' efforts to keep new exchanges
out have drawn scrutiny from regulators and enforcement agencies. In
2013, the European Commission accused 13 of the world's largest
investment banks of colluding to keep new exchanges out of the
credit derivatives market. The U.S. Department of Justice has also
launched a probe into alleged collusion in those markets.
DISRUPTING BANKS' BUSINESS MODELS
The 2010 Dodd-Frank financial reform law requires many kinds of
derivatives to trade on exchanges. But the banks' refusal to deal
with a startup platform is a potent weapon, because market players
want to trade on exchanges where there is high volume. Together, the
big banks control over half the liquidity in the market, giving them
the power to decide which platforms survive, and which die.
Last year, when a swaps exchange run by GFI Group said it would
allow anonymous trading, several banks threatened to pull their
business off the platform, according to people familiar with the
matter. GFI reversed course.
"The big banks want desperately to preserve the status quo," said
Tod Skarecky, Vice President of Clarus Financial Technology, a data
and technology firm specializing in derivatives markets. "This is
disrupting their whole business model."
Senior bank executives said their decisions about which exchange to
use are based on demand from clients. Senior bank officials said
their clients prefer to trade openly with big banks because it is
more efficient and is part of a broader relationship with a bank
that customers value, including access to investment products and
free research.
"If we had a bunch of clients coming saying they want to use trueEX,
then we'd use trueEX," said one senior bank executive. “We just give
clients what they want."
TrueEX CEO Sunil Hirani said 62 buyside firms, such as investment
and hedge funds, have signed onto his platform. "Clearly the buyside
demand is there," he said.
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All the other swaps trading platforms, which have long dominated the
market with the banks’ blessing, including Tradeweb, which is owned
by Thomson Reuters and 11 banks, and Bloomberg's swap execution
facility, require participants in swaps deals to disclose their
identities after they trade, giving dealer banks and other market
participants potentially valuable information about the trading
patterns of big investors.
"Anonymous trading is the obvious solution. It's fantastic," said
Michael O'Brien, director of global trading for Eaton Vance Corp, a
Boston-based investment fund manager. "I don't want to show the size
of my trades, I don’t want people to know how I’m trading.
Information is the most valuable asset we have."
New participants, like trueEX, leads to a more efficient,
transparent, and fair marketplace for all participants, said a
senior hedge fund executive who uses trueEX.
A spokesman for Bloomberg declined to comment. Lee Olesky, CEO of
Tradeweb, said in a statement that Tradeweb's 34% market share so
far in 2015 demonstrated it was providing the desired features to
traders.
"The current trading protocols in play have worked well in
supporting swaps trading without disrupting traders' ability to
access liquidity, and this is reflected in our leading market
share," Olesky said.
Before the financial crisis, banks traded swaps outside of
exchanges, leaving them with hundreds of thousands of trades on
their books with customers and other banks. Those trades meant that
every bank was connected to every other market participant through a
dense web of trades. If any one bank failed, other banks connected
to the wobbly player could fail too, creating chaos in financial
markets.
In a world with exchanges and centrally cleared trades, that risk is
reduced. The clearinghouse, sometimes connected to the exchange, can
ensure that every party's trades are properly collateralized, and
that the failure of one party will not threaten the financial
system.
But ensuring that existing trades are sufficiently collateralized is
not enough, analysts say. If the market is heavily concentrated,
with a few banks controlling most of the trading volume on a few
exchanges, the failure of one big party or another shock to the
system, can still be disastrous because of the impact it would have
on trading volume, they added. Such so-called liquidity shocks can
freeze up markets, and cause massive price fluctuations that can
ripple through the system.
"The whole idea of financial reform was to reduce systemic risk and
part of reducing systemic risk was to open the market up so that
important markets like interest rate swaps had more players on the
bank side providing liquidity and that's not what has happened,"
said Kevin McPartland, the head of market structure and technology
research for Greenwich Associates, a financial markets research firm
based in Stamford, Connecticut.
If anything, market concentration has increased in recent years. The
top five interest rate swaps-dealing banks have increased their
share of that market to 65% last year from 55% in 2012, according to
a study by Greenwich Associates. It is unclear how that has changed
since trueEX began gaining momentum.
Other upstarts have failed to gain any traction. One of them, Tera
Exchange, announced on Feb. 27 that it was shifting its focus to
bitcoin derivatives.
(Reporting By Charles Levinson; Editing by Martin Howell)
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