A regular theme in Profit & Loss and Digital FX over the past year has been the slow advance of e-trading into the derivatives market. The interest rate swaps (IRS) market in particular seems ripe for e-trading as it fulfils two basic requirements – volume, which surged from $54,072 billion at end-June 1999 to $89,995 billion at end-June 20021 and a degree of standardisation.
To date, ventures have tried and failed to tap into the IRS market. But now a new entrant is preparing to launch with a business model it hopes will encourage and support healthy volumes.
Swapstream is due to go live in May, having completed testing in December, and hopes to benefit from the increase in volume and standardisation. The Bank for International Settlements (BIS) believes the volume surge to be a result of the euro market using IRSs as a benchmark, and the reduced issuance of US Treasuries resulting in greater use of the dollar IRS market. Standardisation has resulted from banks changing their processes to hedge buckets of risk, predominantly in the five and 10 year markets.
Swapstream was originally funded by Gottex Brokers in Switzerland (hence the platform will initially support euro and Swiss franc trading), but has since acquired further funding from Chicago-based private equity group FCT, which has become the platform’s largest shareholder. Gottex has retained a share, as has the management of Swapstream; the company has also set aside equity for its liquidity providers.
Marcus Grubb, CEO, says the platform’s liquidity providers can either take equity options in the group or receive a rebate on their dealing fees. Both are dependent upon minimum volume requirements (MVRs) agreed with the liquidity providers prior to launch. “Market making banks on the system have to submit curves and liquidity providers agree to minimum trade volumes,” he explains. “This ensures that we will have good liquidity committed to the system even before it goes live. I think this is very important; we must have a strong commitment from the major players if we are to be a success. We have not taken a ‘build and they will come’ approach.”
The initial launch will be supported by Gottex and another as yet unnamed broker, as well as six banks. Grubb is reluctant to reveal names at this stage; however, he does assure that “all are major market makers”. Grubb says that Swapstream is currently lining up a second group of users which it hopes to have live on the system very soon after launch. He notes that the platform is specifically aimed at the interbank and inter-dealer broker markets.
As noted earlier, other projects in the IRS market have failed to achieve the desired level of success; however, Grubb is confident Swapstream’s name will not be added to the list that includes Blackbird, CFOweb and Treasury Connect. “This is effectively a new initiative for the IRS market,” he suggests. “Other enterprises have been built very much along the lines of a new e-broker model; however, we have modelled ourselves upon the ECN principle. We deliver the trading system reliably and are responsible for the system performing to customers’ expectations in handling critical order and trade information. We do not participate in the transactions themselves and do not alter the way the market operates today.”
Swapstream has attempted to replicate offline functionality as much as possible, to the extent that users have the option to view prices from the interbank market only, or – with one click – they can also access broker liquidity. Users have all available liquidity on one screen, something that is a prerequisite for any multi-provider platform, and can negotiate the details of trades in an open and transparent environment. All parties to a trade have the relevant information displayed simultaneously.
The core page on the system provides pricing in two brackets: one year to 10 years and 10 to 50 years, as well as two spread matrices in the one year to 10 years and 10 to 50 years. This page provides a snapshot of the market: prices in white are indication only; yellow signifies the price is live from another bank, market maker or brokers; and blue if the user’s own price is best bid or offer in the market. Users can enter a price outside the current market spread; however, it will only be seen on the main screen if it is best bid or offer. Entering prices is a simple process, one click on the price concerned, define the nominal amount and send.
Prices can be directed to individuals or a group of users and the price maker has the option of accepting partial fills on a hit. A recent price making enhancement is the ability for market makers to link their prices to the underlying futures contract such as the Schatz, Bobl or Bund. If a price maker chooses, an automatic link can be opened to ensure that for every pip movement in the futures contract, the swap price on the system is adjusted by a predefined amount (which is configurable by the price maker).
Any price input into the system generates a price in the spreads involving that period. Market makers can also remove or generate curves on the platform (from their own pricing system or spreadsheet) with one click.
Underpinning the price information screen is an order box window which allows permissioned users to see further details such as depth of market and whether the price maker allows partial fills (indicated by ‘p’); if the trade is via a broker (b); or subject to a spread trade (s).
The selected tenor is ranked by orders and size, but unlike an exchange, Grubb says price takers can hit anywhere in the market to ensure, for instance, that an amount is executed in one ticket. “We think it is important that users do not have to hit the first or best price if they have a large amount to execute,” he says. “This is especially important for the larger players in the market.”
Executing a trade is a three click process, the first generates an “are you sure?” box; a second produces the dealing ticket with all details displayed; and the third click actually executes. Names are passed at the second stage of the process. Grubb explains that bank credit officers may input buckets of credit into the system and, assuming the parameters of the trade are within limits, the counterparty name appears in green. If there is a credit issue to be resolved – for example, the amount may be above the credit limit allocated to the system – the name appears in yellow and a dealer has to follow normal offline credit checking procedures.
An ‘open trade’ box is displayed on screen for users to view trades in the process of execution (dealers can pull out at any time until the execute button is clicked). Confirmations are sent to all parties of the trade simultaneously and are also displayed on screen for information purposes.
A real strength in the Swapstream system, from an outside perspective, is in the negotiation and spread trading functionality. Once a trade is in the process of being executed, the parties to it can open up a negotiation box to arrange details such as the reference rate. It is not just that the negotiation process can take place online (with the commensurate hard copy for audit purposes), but also that once the details are agreed they can be sent to the system and a new deal ticket is automatically generated. “The parties to a trade can negotiate the details to and fro and thus generate several prospective tickets,” says Grubb. “However it is more likely they will agree the details first and then generate the ‘final’ ticket.”
To execute a spread trade, the process is similar – a click on the price generates a ticket, but the price taker is alerted that the trade is subject to a spread trade and therefore may take longer. The parties are committed to the trade during name checking unless the market moves. If it does, and one party pulls its price, the spread cannot then be done. It is impossible in Swapstream to be “hung” on one leg of a spread trade. If all is OK with the trade, it is instantly executed in all tenors.
“We believe that this automated functionality linking swaps and spreads multilaterally in real time is unique and will help dealers and inter-dealer brokers to manage their spread trades,” explains Grubb.
As noted, the initial launch will see Swapstream support euro and Swiss franc trading; however, Grubb reveals plans to support dollar trading before the year-end, as well as euro short swaps, which will bring it into competition with e-Mid. “Our User Board, which provides guidance rather than governance, will decide which of these markets is launched first,” says Grubb, who appears unconcerned about competition. “I feel there is room in a market as large as this for more than one system,” he adds.
This sentiment could be tested in the year ahead. Aside from e-Mid at the shorter end of the market, Swapstream could face competition from another Reuters 50/50 joint venture, Icor, which is also looking at supporting interest rate derivatives trading as noted in the Q4 2002 issue of Digital FX.
Grubb says building numbers of users is primary among Swapstream’s near-term aims. He is also keen to stress that in addition to encouraging as many market makers online as possible, Swapstream is also looking for price takers. There is a possibility of other inter-dealer brokers joining the system, and some have expressed an interest in doing so. However, he adds that many brokers have their own hybrid models to support trading, and are therefore more likely to be competitors. This would appear to rule out the world’s largest inter-dealer broker, Icap, joining the system, at least in the near future.
Other areas of interest for Swapstream include initiatives such as post-trade processing. Although Grubb is reluctant to discuss links with outside organisations at this stage, he concedes that Swapstream has “a good relationship” with SwapsWire, which launched at the end of 2002, as well as other initiatives in the IRS market.
“We are very flexible over where a trade goes once it has been executed on Swapstream,” he adds. “We want to be the dominant trading system in the IRS market and will work with other initiatives in the processing area to provide our users with the best possible service. We are FpML and Swift-compliant, so we can provide a big efficiency gain if we link our trading engine to processing solutions, primarily through error reduction and the reduction of dealing desk administration.”
As launch nears, Swapstream expects to be in a position to announce further users and alliances, similar to that announced this month with Deutsche Bourse for the latter to host the company’s technical infrastructure. “The Deutsche Bourse link up assures potential users that we have the technical resources and a robust enough offering to support trading,” says Grubb. “As a small company we would find this a difficult proposition. We have a good relationship with Deutsche Bourse as a key technology supplier, but I would stress we are an independent operation.”
With technology and liquidity support assured, it would appear that Swapstream is in as strong a position as it could hope to be ahead of actual launch, which leaves just one question to be answered. Is the market ready for online execution of more complex derivative transactions such as IRSs?
Grubb is confident that it is. “There are still complex instruments that are unlikely to trade online in the foreseeable future,” he acknowledges. “But in general, the market has become more standardised due to the concentration of risk and the work done by ISDA for example. Initiatives such as Swaps Clear and SwapsWire have automated much of the post-trade process. Futures trading is mainly online, so I would argue that the time for e-trading of plain vanilla swaps is getting close.”
1Source: The Bank for International Settlements semi-annual survey of global OTC derivatives positions outstanding (amounts are notional for single currency contracts only).