Trading firms blocked on swaps

IFR 2140 2 July to 8 July 2016
5 min read

UK and US proprietary trading firms looking to make markets in swaps are struggling to find clearing partners, with banks allegedly blocking access to firms seen as potential competition, according to sources close to the situation.

Proprietary trading firms are active market-makers in short-term interest rate futures, but have seen volumes declines amid historically low interest rates. Many see electronically-traded swaps as a natural addition, but have found themselves blocked by incumbents.

“Most of these firms are active in short-term interest rates on ICE, and to give themselves more clout would be like to trade over-the-counter products that are now being cleared,” according to one industry executive. “They are starting to trade electronically [in swaps] but the clearer is also the dealer of OTC derivatives and they don’t like the idea of these guys coming in and diluting the market.”

Prop trading firms rumoured to be considering moving into swaps market-making include OSTC, Tyler Capital, Maven Trading and Financial Markets Engineering in the UK, and DRW Trading, Eagle Seven Trading and WH Trading in the US. None of the firms were immediately available for comment.

“What I hear is that the clearing firms are saying that they won’t clear for these firms if they are going to compete in the swaps space,” the executive said. “Large buyside firms would also like to see more liquidity in swaps but are afraid of offending clearing firms.”

RFQ dominates

Dealer reluctance to share liquidity provision in the swaps market is also the reason behind the failure of central limit order book functionality in the swaps market, the executive said.

“Dealers in the US have imposed rules on clients saying that you need to do name give-up, and that has killed the CLOB market.”

SEFs operators including Bloomberg, Tradeweb and ICAP offer order book functionality but have seen the vast majority of swap volumes concentrated on their request-for-quote platforms, which offer transparency as to the transacting counterparties.

One non-bank to have successfully broken into swap market making is Citadel Securities, which has built a successful franchise based on a low-price, technology-driven service. In October last year, Citadel joined LCH as a clearing member, initially to clear its own trades.

While Citadel has managed to win market share, prop trading firms face an uphill struggle breaking into the relatively illiquid OTC market.

“If you want to be a market-maker you need to go into that market with sufficient liquidity so that you are not run over or picked off,” said Tom Lehrkinder, a senior analyst at Tabb Group. “So it’s not surprising they are cautious.”

Swaps trading volumes are far below those in futures, where prop trading firms have established themselves as among the most active market-makers. There are around 3,000 swap trades per day, according to ISDA Swapsinfo, while interest-rate futures activity on CME Group exchanges amounts to around 7m trades a day.

Legal challenge

Concern over access to swap markets is not new. In March, allegations were added to a lawsuit alleging that 12 of the world’s biggest banks have routinely used clearing as a weapon in the battle to retain market share.

Lawyers for the Public School Teachers’ Pension and Retirement Fund of Chicago alleged that banks refused to provide clearing services to clients that tried to use new trading platforms to break into swaps.

The complaint alleges that Goldman Sachs threatened to cut off all clearing services for its client NISA Investment Advisors if the large buyside fund continued attempting to trade through an all-to-all anonymous trading platform operated by Javelin Capital Markets.

“Goldman Sachs’ FCM was willing to forgo clearing revenues and damage customer relationships in order to shut Javelin out of the market,” the amended complaint says.

“There is no legitimate reason that a [bank clearer] should discriminate among [trading platforms] because its risk comes from the client trading entity itself, not the platform on which the trade is executed. The [bank clearer] earns a commission on every trade it clears.”

In another example, BNP Paribas is accused of threatening to pull clearing research and execution services for clients Annaly Capital Management and Mizuho Bank when the two firms executed a trade on start-up platform TeraExchange in the summer of 2013.