A new trading exchange for derivatives is loosening the stranglehold that the world’s biggest investment banks have on the multi-trillion dollar market in a crucial test of financial reforms that attempt to reduce systemic risks.
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 GS.N, Deutsche Bank DBKGn.DE, Citigroup C.N, Barclays BARC.L, Bank of America Corp BAC.N, and Morgan Stanley MS.N, 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 JPM.N, 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 GFIG.K 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.
All the other swaps trading platforms, which have long dominated the market with the banks’ blessing, including Tradeweb, which is owned by Thomson Reuters TRI.N 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)