New U.S. rules to decide fate of noisy swap brokers

NEW YORK Tue Jan 29, 2013 6:05am GMT

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NEW YORK (Reuters) - Twenty casually clad men crowd around a screen at derivatives broker GFI (GFIG.N), shouting prices at each other and to clients on the phone.

It is one of the noisiest parts of a male-dominated trading floor where shoe shiners crouch in a corner, smells waft as caterers bring around food, and one man gets a back massage at his desk.

At rival ICAP (IAP.L), a huge whiteboard on a wall has names of banks scribbled all over it, with prices of trades behind them. Every so often, a trader gets up, erases a number, and adds a new one with a marker pen.

Even as regulators around world are bringing the opaque and clubby $630 trillion derivatives business into the open, there will likely remain vestiges of old-school trading practices such as brokering deals over the phone.

U.S. regulators had originally limited "voice broking" in a proposal issued in early 2011.

The thought was that the practice - in which brokers work the phones to match buyers and sellers of often thinly traded and complex financial products - runs counter to efforts to shed light on so far unregulated derivatives.

But the industry fought back, arguing that these phone calls do not give rise to shady deals. They also contend that many of these derivatives deals are so customized that they need a human touch, not just an electronic execution of a trade.

The brokers are expressing hope that the top U.S. derivatives regulator - the Commodity Futures Trading Commission (CFTC) - has listened, and is now poised to soften the restriction on voice broking in the coming weeks.

"The misconception is that voice-brokerage is bilateral. The misconception is that Goldman calls up GFI to connect them with JPMorgan, whispering in the phone," Chris Giancarlo, GFI's head of strategy, said in an interview.

But no trader at these banks would pay a broker just to speak to another firm, he said. "Why pay a broker? You only go to a broker because you want to see the whole market."

MATCHMAKERS

In the future, all but the most exotic derivatives will need to be traded on exchange-like platforms, which firms like ICAP and GFI hope to run. Still up for debate is how much of the trading can take place over the phone.

Unregulated derivatives - used to hedge risk, but mainly a playground for speculators - were at the heart of the 2007 financial crisis, when a sudden crash in these complex financial instruments caused hefty losses at banks.

Wall Street banks such as JPMorgan (JPM.N), Citibank (C.N) and Bank of America (BAC.N) are the main dealers, but ICAP and GFI are among a handful of matchmakers that broker trades between buyers and sellers of derivatives.

Known as interdealer brokers, they enable the banks to trade without having to pick up the phone to talk to their arch rivals, and risk disclosing commercial information.

The actual broking takes place over the phone, but prices are often entered into an electronic system as soon as a deal has taken place, for all to see.

They charge a fee - typically in the order of $20 to $60 - for each trade they bring about, but they do not trade themselves. Tullett Prebon (TLPR.L), Tradition (CFT.S) and BGC (BGCP.O) are the other main players.

Sharing annual turnover of some $8 billion, the five brokers run a modest industry, but are an important part of the market, with the lion's share of the trillions of dollars worth of trading passing through their hands each year.

MARKET FORCES

Bart Chilton, one of the CFTC's five commissioners who will decide the issue, said last year at a conference in New York that he was in favour of keeping voice broking in place.

"I stand by what I said that we need to allow voice brokers. That said, it doesn't mean we shouldn't have transparency and reporting of voice brokers," Chilton told Reuters in an emailed statement this week.

In the coming weeks, the CFTC is due to decide on voice broking when it votes on final rules for the new swap trading platforms, known as Swap Execution Facilities (SEF).

But even if hard lobbying by firms such as GFI and ICAP has saved voice broking for now, the industry recognizes that market forces mean the practice is inevitably on the decline.

Global rules on derivatives and the 2010 Dodd-Frank financial reform law give preference to more standardized swap products that can be traded on electronic platforms so as to increase transparency.

ICAP made more money from electronic broking and other services than from voice broking in 2012 at an operating profit level, the company's annual report shows.

New entrants such as Bloomberg, Tradeweb (which is majority-owned by Thomson Reuters (TRI.TO)) and MarketAxess also form a threat, aiming to become SEFs and offering electronic platforms without relying much on phone trading.

"Market parties want more transparency... It's just a business evolution," Lee Olesky, Tradeweb's chief executive officer said in an interview.

Cutting down on voice broking could also mean higher margins for the firms. For each trade they match, a broker takes home roughly half of the fee. As a result, these companies spend more on compensation even than investment banks.

Still, with the market forces shifting, it will not be immediately clear if and when the noisy trading floors will become a thing of the past.

"It's going to continue to evolve and ... the real big change is not going to be super-apparent for another year to 18 months after the rules are finalised," said Tradeweb's Olesky.

(Reporting by Douwe Miedema; Editing by Karey Wutkowski)

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