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April 2012
Far from signaling the end of singledealer platforms, the impending raft of new regulation in the US and Europe will create a new business environment in which the direct online channel is more important than ever for both banks and their clients.
Paul Caplin, CEO of Caplin Systems Ltd. founded the company in 2000
Soon after the publication of the Dodd Frank act in the US, some early commentators suggested that the forthcoming prohibition of bilateral trading of liquid swaps signaled the death knell of single-dealer platforms (SDPs), the banks proprietary online trading offerings. But, as with Mark Twain, reports of their death were greatly exaggerated. Far from backing away from SDPs, virtually all tierone banks and many smaller firms have responded to the imminent shift in market structure by increasing their spending on SDPs.
According to FX Week, the head of foreign exchange at a top-tier bank recently described this as the secret weapons program now under development at most banks. The successful SDP of tomorrow will provide essential customer services in a fragmented multilateral marketplace. It will deliver swap execution facility (SEF) and organized trading facility (OTF) aggregation and smart order routing, integrate this smoothly with OTC trading of illiquid/off-the-run instruments, and link it to the clearing and collateral management
services through banks will actually make most of their money as parts of their business switch from a principal to an agency based model. Banks that understand and embrace this will establish a secure and profitable position at the centre of their clients trading workflow. This paper explains how this will work, and looks at what banks stand to gain from proprietary online channels in the new world order.
We reaffirm our commitment to trade all standardized OTC derivatives contracts on exchanges or electronic trading platforms, where appropriate, and clear through central counterparties (CCPs) by end-2012 at the latest
From the communiqu of the G20 summit, Toronto, June 2010
April 2012
Liquidity fragmentation
At the time of writing, around 40 firms are planning to register as SEFs in the US, and/ or OTFs in the EU. Some of these will fail, of course, but there seems to be a general expectation that at least 3-4 will survive and compete in each asset class in each region, and this number may grow over time. Recent research from Rule Financial shows that buy-side users are already expecting liquidity to fragment across multiple venues under the new regime (see Figure 1 and Figure 2). David Holcombe of Rule Financial comments that these show an expectation to use the platform thats already on your desktop to address day one regulatory burden, and that this initial concentration of liquidity in major venues such as Bloomberg is likely to be dissipated as the market fragments with new entrants into the SEF space perhaps particularly those with a business case enhanced by SEF aggregation taking market share from the incumbent MDPs.
Fig. 1 Buy-side predicted future execution venues for IRS Source: Rule Financial2
Fig. 2 Buy-side predicted future execution venues for CDS Indices Source: Rule Financial3
Figure 3 (overleaf) shows some of the new entrants to the SEF space in the US. This community is clearly still growing. But it is still more complicated than this, because many swaps will be too illiquid or specialised to be centrally cleared, and so will continue to trade through OTC dealers. As a result, market participants will in general need to continue to trade OTC as well as via SEFs and OTFs.
At the same time, new challenges in understanding and managing risk in the aftermath of the credit crisis has greatly accelerated the pace of migration to electronic trading of OTC products, even without new regulation. For example, less than three years ago hardly any credit default swaps (CDSs) traded electronically. Now, more than 90% of the trading in some Index CDSs is electronic.
April 2012
Liquidity aggregation
We have been here before: this combination of a transition to electronic trading plus market regulation is what caused the equities marketplace to expand from a handful of national stock exchanges in the late 1990s to a huge range of ECNs today. The US equities market alone now has over 50 execution venues, and 37% of all US equity trading is now executed away from exchanges. In response to this, the buy side sends nearly 40% of its order flow through algorithms designed to aggregate the liquidity and manage it efficiently. The same kind of outcome is widely expected in the OTC market. As liquidity becomes fragmented, users will need to aggregate and manage it across multiple venues to achieve best execution. Banks that want to retain their customers will need to provide this service. This is not a controversial view: TABB Group reports that 87% of swaps dealers are already either building or about to build SEF aggregation technology , and that over 70% of respondents in each asset class thought that SEF aggregation would become common once the new rules were in place (see Figure 4). Banks such as Deutsche, RBS and UBS have already announced their plans to offer this kind of service7
Fig. 4 Percentage, by asset class, who believe SEF aggregation will become common Source: TABB Group6
April 2012
Fig. 5 What will happen to single-dealer platforms post Dodd Frank? Source: TABB Group10
Fig. 6 Total FX swaps volumes through single-dealer platforms vs. multi-dealer platforms Source: Caplin/Bank of England data
April 2012
Conclusion
Faced with a revolution in OTC trading in the US and EU, banks need to bring their clients with them as they adapt to the new order. They can do this by helping those clients cope with challenges such as liquidity fragmentation and collateral management. An effective single-dealer platform is key to achieving these goals. That is why, far from retreating from SDPs in the face of new regulations and market changes, leading banks are now investing in them more heavily than ever.
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References 1. TABB Forum, 29 September 2011: Can Single Dealer Platforms Become Organized Trading Facilities? http://www.tabbforum.com/opinions/can-singledealer-platforms-become-organized-tradingfacilities 2. Rule Financial, 12 March 2012: Dodd Frank 18 months on, is the landscape any clearer? 2012 Rule Financial OTC clearing and collateral management survey results http://www. rulefinancial.com/about/news/launch-of-2012otc-clearing-and-collateral-management-report. aspx 3. Rule Financial, 12 March 2012: Dodd Frank 18 months on, is the landscape any clearer? 2012 Rule Financial OTC clearing and collateral management survey results http://www. rulefinancial.com/about/news/launch-of-2012otc-clearing-and-collateral-management-report. aspx 4. The OTC Space, 2 April 2012: State of the ecosystem snapshot http://theotcspace.com/2012/04/02/ state-of-the-ecosystem-snapshot 5. TABB Group, October 2011: Credit and Rates Swap Dealers 2011: Redefined and Reborn http://www.tabbgroup.com/PublicationDetail. aspx?PublicationID=996 6. TABB Group, April 2011: Swaps Liquidity Aggregation: Best Execution to Product Selection http://www.tabbgroup.com/PublicationDetail. aspx?PublicationID=1032 7. See for example: http://singledealerplatforms. org/2011/10/15/ubs-to-enable-clients-to-routeswaps-orders-to-sefs 8. Rule Financial, 2012: OTC clearing and collateral management report http://www.rulefinancial.com/about/news/ launch-of-2012-otc-clearing-and-collateralmanagement-report.aspx 9. FX Week, 19 Dec 2011: The Secret Weapons of E-Commerce http://www. fxweek.com/fx-week/opinion/2133269/ secret-weapons-commerce 10. TABB Group, 1 December 2011: SEF Industry Barometer: Fall 2011 http://www. tabbforum.com/channels/fixed-income/ researches/sef-industry-barometer-fall-2011 11. EuromoneyFXNews e-trading survey http://www.euromoney.com/Article/3007022/ Category/16/ChannelPage/3301/ EuromoneyFXNews-e-trading-survey-Actionstations-for.html
April 2012
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Caplins Web Trading Technology provides an HTML5-ready framework for building fully featured Web trading applications that run in a standard browser. Our technology serves over 100,000 endusers at financial institutions that include ANZ, Barclays Capital, Crdit Agricole, Citi, MarketAxess, Nomura, RBS, Standard Bank, TD, UBS and UniCredit. Our domain experience sets us apart from companies providing generic technology frameworks. Caplin Systems is privately held and headquartered in the City of London.