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The Electronic Threat

How will the Internet change derivatives trading? No one knows for sure, but everyone’s got an opinion.

By Robert Hunter

When on-line retail equity trading systems such as E*Trade and Ameritech first burst into the American financial consciousness, people on the institutional side of Wall Street paid little attention. After all, they argued, traders and salespeople in the capital markets provided far more value to their customers than mere blips on a screen ever could.

But Wall Street quickly shook off its complacency as the day-trading boom took off. Before long, Merrill Lynch and other brokerage firms were offering internet trading to their retail clients. And nowadays, brokerage firms of all types are looking in the mirror and wondering what role they’ll play in a world of cheap trades and quick execution.

Will the sweeping changes that have swept the retail brokerage business affect the derivatives world? Why, after all, should an end-user deal with a broker or dealer to execute a plain vanilla swap when thousands of like-minded players can be brought into direct contact with one another via the Internet? And what meaningful added value could a broker or a dealer provide in a vanilla swap deal to offset the unprecedented market transparency and liquidity the Internet can offer? Many believe that Internet technology will give end-users enormous power, making them less reliant on banks and brokers for financial information and linking them to the rest of the financial world in ways never before possible. Indeed, a number of Internet-based trading systems for derivatives are slated for release in the next few months. (See “The e-Players,” Page 19.) \

The biggest vehicle for such a transformation appears to be the on-line auction. If the wild success of E-Bay taught the financial world anything, it’s that there’s a market for just about anything, and people are dying to get together to trade. If Beanie Babies can be traded en masse, why not derivatives products? “An auction-based system is inevitable,” says Lloyd Altman, general manager of the capital markets practice at Random Walk, a New York-based consulting firm. “That’ll allow anyone who qualifies to make a market in something to be able to submit quotes and bid. I see that happening for all kinds of swaps and vanilla OTC derivatives, the types that are quoted many times a day.”

Once traders are connected, of course, it’s only a matter of time before all trading and risk management functions are brought into the Internet information loop. A client who wants a five-year swap with certain characteristics, for instance, will be able to inform his trader via the Internet to scour the on-line auction site for deals that fit his or her parameters. When the trader finds the deal, the information will travel to both counterparties’ middle and back offices for risk management and settlement operations.

The key buzzword in this discussion is “disintermediation.” Derivatives dealers are financial intermediaries, structuring products with one end-user and laying them off on another. But when end-users are able to connect directly with each other, dealers may find themselves on the outside looking in. Some even believe the distinctions between bank traders and salesmen will blur. No longer the gatekeepers to the firm, traders could become more like customer service agents, taking care of their clients. Kevin Dick, a Palo Alto, Calif.-based consultant, likens the new role of the trader to an account manager, “basically making sure clients are happy.”

Brokers going broke

The hardest hit in all this may be the interdealer brokers, who live off the cloudiness of the financial markets. Internet trading sites will burn clear through such obscurants, exposing the depth and breadth of markets in jarring clarity. “You’ll see the total disintermediation of secondary players, wholesale players like interdealer brokers,” says Carl Carrie, president of CastleNet, a New York-based software vendor.

“You’ll see the total disintermediation of secondary players, wholesale players like interdealer brokers.”
Carl Carrie
CastleNet

As the brokers are squeezed, their roles will change. “The broker won’t be a person who just matches buyers and sellers,” says Larry Tabb, group director of securities and investments practice at the Tower Group, a research and consulting firm. “They’ll either have to assist in terms of content and knowledge, providing val-ue-added services besides buying and selling, or they will have to come to the market with capital, taking on trades and off-setting their positions.” Brokers’ new domain will be the exotic side, he says. Only the people who can provide added value, who can help people understand what products they need to buy and sell and when, and who know how to structure deals, will stick around.

Some say the best chance for brokerage firms will be in the back office. “With a far more liquid, more transparent market, the brokerage end will suffer,” says Octavio Marenzi, a director at Meridien Research. “There won’t be much money to be made in brokering anymore—the money will be in the clearing end of things. Brokerage firms will become processors more than anything else, rather than companies that make markets and take positions with their clients.”

Bigger changes

Some even argue that to look at banks’ roles as being disintermediated understates the case so much as to miss the point entirely. “Disintermediation is a relatively narrow view of the change the Internet will bring,” says Steve Katzman, global industry manager in securities and capital markets at Sun Microsystems. “You’re not just saying, ‘We provide derivatives structuring and trading services, let’s make a more direct connection.’ The services themselves are going to change, because we’re changing the very walls around institutions. One of the reasons the walls have been where they have been is because people have had in-house control over their operations. But now, technology is changing the very definition of an institution, allowing functions to spread across different institutions. So it’s a bigger change, a bigger earthquake than just disintermediation of some of the middlemen. It’s a redefinition.”

CastleNet’s Carrie agrees. “We will see continued elimination of corporate salespeople at banks, and we will see traditional banking, insurance and financial services blur into one another and be provided by targeted and re-branded Internet portals with incredible cost efficiencies. Banks and insurance companies will vie for eyeballs and financial services with the likes of Yahoo. You’ll no longer need traditional archaic entities in between. These older business model-based companies can’t continue to provide the superior cost-economics and service advantages that low-cost connectivity and highly personalized e-services will.”

Such sweeping changes may take years to materialize. But in the meantime, there’s no question that banks’ roles will change as more market information reaches customers’ computer terminals. The bigger banks will always make money off their huge interbank trade flows, but the smaller banks won’t be as lucky. As the Internet redefines the way banking is defined, smaller players will have to put all their efforts on innovation and new product development.

Banks of all size may also see some of their middle- and back-office functions splinter off to other firms. “It’s quite feasible that over-the-counter deals will increasingly be cleared by a large clearinghouse,” says Patrick Young, an independent trader and author of Capital Market Revolution. “Maybe you’ll see a big boys block-trading facility, and next to that a smaller facility for retail and medium-sized institutional players.”

Meanwhile, clean, fast market data distributed over the Internet is not as far away as once thought. A number of leading vendors have begun promoting software that purports to do just that, but none has yet gone live with a real-time, two-way data flow. In most scenarios, data are grabbed statically every few seconds. CastleNet’s July announcement of an agreement with Bridge is the industry’s best effort to date.

“It’s a bigger change, a bigger earthquake than just disintermediation of some of the middlemen. It’s a redefinition.”
Steve Katzman
Sun Microsystems

Once such systems are in place, rich, real-time data will be ubiquitous, improving not only trading operations but overall industry sophistication. Real-time market and trading data feeding directly into company-wide risk management systems can only hasten the convergence of trading and risk management. When evaluating, say, an exotic equity option, a trader with a full-fledged volatility term structure, rich with historical information, is far more helpful than a standard volatility calculation. “Having an integrated approach to pricing and trading on one desktop is really where most of the capital markets firms are going,” says a software vendor.

Not so fast

Not everyone is convinced that the Internet will live up to these futuristic predictions. Even the on-line auction concept has its skeptics. While most agree that on-line trading marts will probably emerge in vanilla swaps and other highly liquid products, there’s no such consensus on the exotic end, particularly in dealer-client structured products. “Customers need custom solutions, and every customer is so different that every transaction has to be looked at closely and priced accordingly,” says Murugan Manivannan, president of FinTrack Systems Corp., a New York-based Internet financial software firm that offers real-time Internet trading between dealers and customers.

Another vendor agrees. “Clients don’t come up and say, ‘I want to trade a double barrier with a window barrier on the first three months and I want the whole structure done in Canadian dollars. Price it for me.’ It doesn’t happen like that. That’s why salespeople get fat bonuses compared with traders.”

Indeed, some envision only gradual changes. “The changes will not be as brutal or revolutionary as they have been in retail business, in e-commerce,” says Maroun Edde, a manager at Murex North America. “In e-commerce, you have the complete redefinition of where the economic value is, and people who still do business as they used to two or three years ago are completely gone. In OTC derivatives, it’s a little subtler. The distribution of financial information will change, but that doesn’t mean there will be a revolution.”

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