There is no shortage of things the industry needs to talk about, thanks mainly, it seems to me, to the seemingly never-ending merry-go-round of US litigation against the banks. The latest issue raised is an old one – liquidity and the misconception that it is an apparently valueless commodity.
I spend way too much time reading through US litigation documents, but I’d better get used to it, because I don’t think the supply of material is going to slow down anytime soon – the latest involves a lawsuit brought by interest rate swaps trading platform TrueEx, against a group of banks, claiming the latter colluded to “boycott” the firm’s trading and clearing platforms to preserve their profit margins.
The bare bones of the case is that TrueEx alleges that the banks favour Tradeweb, in which they have a part ownership, although it has to be noted that the lawsuit also takes a swing at (but does not include in the defendants) ISDA, the FIA, the IDBs and Bloomberg, suggesting they are bullied into maintaining the status quo by the dealers.
At face value this lawsuit seems something of a petulant and desperate attempt to grasp at straws before the platform goes under – I have always considered financial markets to be a democracy and as such LPs can price and stream where they like. It has to be noted, however, that collusion and cartel activity, such as that alleged in the filing, are restrictive activities and so, we are yet again at the stage where the lawyers are involved.
Having gone through the document (yes, I know, I need to get out more), a couple of things stand out. Firstly, the lawsuit states, “An IRS trading platform is relevant only when it includes the participation of nearly all of the major liquidity providers.”
Elsewhere the lawsuit refers to the “grossly inflated spreads” charged by LPs on other (non all-to-all) platforms and there are persistent references to the worse conditions available to clients because they have to operate in a dealer-to-client world.
The US legal system will decide these arguments in good time (assuming the banks don’t collectively roll over again like they did so weakly in other areas) and, hopefully, the jury when it is named (assuming it gets that far) will better understand the functioning of markets better than they did in the Mark Johnson case.
Away from the grinding legal process we are about to witness, I think the fact the lawsuit has even been brought highlights one of the problems in our world – too many people still think liquidity is cheap and easy to provide.
In the lawsuit the document suggests that the dealers should be providing the same liquidity on TrueEx as they do on Tradeweb and other bilateral, name give-up, venues. This is all very well, but if I am a dealer and I want to make a price in $10 million why would I want to split it up? The IRS market is probably a decade behind FX in terms of its developing market structure and FX has already been through the breaking larger tickets into smaller sizes phase and is seeing an increasing amount of interest (from clients) in full amount execution, or at the least fewer LPs in their liquidity pool. Why then, do I, as an LP, want to pay the costs of trading and processing multiple IRS tickets when in reality I can execute it in one amount on one venue?
Equally, given the regulations mean dealers carry less inventory in interest rate swaps, why do I want to be providing liquidity on a constant basis at all unless it is to facilitate a hedge or likewise for one of my customers? The incentives just aren’t there any more.
Of course, if the all-to-all platforms in interest rate swaps had last look then it might be a little different, but generally they don’t and that means the liquidity available is genuine and as much as there is out there. More liquidity cannot be created out of thin air in these products and it seems to me that one of the assumptions being made here is that the major dealers have unlimited liquidity at their disposal, which they should farm out to all venues, as happens in FX. Well the FX market does not present a true picture of liquidity thanks to the aforementioned last look…but that is an argument for another day!
A better, more reasonable evaluation of liquidity is needed across all markets. It should not be seen as a “given” and spreads should be allowed to reflect the quality of flow available. In other words, as a dealer, if I am aware there are some what I consider to be toxic counterparties on a venue, then I have the right to take that into account when pricing there. This is especially the case if the venue is anonymous and I don’t know with whom I am dealing. This is not a restrictive practice in my eyes, rather it is prudent risk management.
Equally, as I have already noted, if I only have a limited pool of liquidity to push out the market, surely it is my right as a trader and LP to decide where I put it? In the past, dealers have been dragged to platforms (sometimes screaming and kicking it has to be said) by the customers, but in FX at least that has now changed. Dealers are focused on the value of flow rather than the volume and that inevitably means they are more choosey about where they stream to.
I think it is this apparent sense of entitlement in the TrueEx lawsuit that has struck me the most and highlighted to me why this case could be very important. Putting aside the claims of collusion – again they will be judged by law – if the outcome is that a platform can force the dealers to stream liquidity to them, there will be unforeseen consequences. The only end result from such an outcome is a bunch of banks exit the IRS business. After all, how many customers or “alternate LPs” want to price to every venue without the ability to reject multiple hits? Few or none is the answer. Just look again at how many alternate LPs (and yes, banks as well) operate in FX predominantly behind last look protocols?
Equally, one of my first thoughts on reading the document was “why don’t the banks just connect and quote wide?” but the lawsuit also highlights that “restrictive practice” and again raises the prospect of yet another bizarre, albeit unlikely outcome. It strikes me that if the plaintiff wins they will not only be able to demand that banks stream to them, but also that they do so at a “competitive spread” which will, of course, be decided by the platform. If that happens then I think we have to finally accept that the lunatics have truly taken over the asylum.
I think this lawsuit also highlights something else in markets – the death knell for that idealist (and delusionary!) vision of a market in which customers are the liquidity providers. After all, if the customers were keen to make markets, TrueEx probably wouldn’t feel the need to bring this action because it would have enough liquidity to facilitate trading.
The fact is TrueEx, and other platforms, will nothave adequate liquidity because the buy side alone cannot provide it – especially when markets start to move. It is also interesting to note that in spite of the entry of such non-bank giants as Citadel Securities into the IRS market, these firms also clearly rely upon the banks to help build a sufficient liquidity pool from them to price off. In other words, and yet again, the key to a successful OTC market model is risk warehousers, albeit in the current world, thanks to regulation, at a reduced rate.
TrueEx may well have a valid claim that there has been a concerted effort to deny it liquidity and connectivity, but one cannot help but feel this is the latest effort to drive home the need for an exchange model where OTC markets currently exist. In the latest In the FICC of It podcast I express my unhappiness at last week’s FCA paper’s conclusions on the Cable flash crash in no uncertain terms and this lawsuit feels like it is pushing the same agenda – that markets will only improve when they are totally transparent and cleared.
I cannot agree with that sentiment because I continue to believe that while exchange traded models are often the best solution for financial firms seeking trading profits and for some heavily commoditised products, for a great many firms in the “real economy”, dealing with Joe Public’s money or conducting international trade there is a need for bespoke solutions, be they in tenor or size of trade.
I will be interested in how this case progresses because one outcome could very easily shake the liquidity model in FICC markets to its foundations. If platforms can dictate that dealers provide liquidity and at certain spreads the only outcome I can see is a bunch of dealers changing their model to the degree that they effectively exit the market. If that happens it will not be a happy ending for anyone; the dealers, the platforms or, most importantly, the customers.