Two New Electronic Swaps Platforms Join the Fray
By Nina Mehta
If you build it, they will come—or so goes the current maxim among Internet start-ups eager to consolidate a portion of the multi-trillion-dollar swaps market. BrokerTec, CFOWeb.com and Blackbird have already announced plans to trade (or launched) interest rate derivatives on-line. Now, there are two more in the market.
The latest initiatives are SwapsWire, a consortium of six large dealers, and TreasuryConnect, a trading vehicle for corporates. Both are starting from the same premise: They don't want to change fundamentally how swaps are transacted. Both further agree that electronic trading will make the swaps market more efficient. But the two are designed to appeal to different markets and will create efficiencies for different market participants.
SwapsWire, which is expected to go live toward the end of this year, is intended at this early stage as a dealer consortium for the on-line pricing and execution of benchmark U.S. dollar and euro swaps, and eventually plain-vanilla interest rate options products. Although it's currently little more than a bare-bones statement of intentions, its owners are JP Morgan, Chase, Deutsche Bank, Morgan Stanley Dean Witter, Citigroup and Warburg Dillon Read—behemoths with no shortage of cash or credibility. The partners say they will encourage other dealers, brokers and customers on the system once it's up and running; for now, though, they want to hold the group down to a manageable size so decisions can be made quickly.
|"We will only do bilateral transactions. We're not an exchange. This is not ebay.”
Morgan Stanley Dean Witter
SwapsWire isn't maneuvering to turn the market inside out. Its stated goal: to replicate the current market structure electronically, rather than create something new. Say, for example, Morgan Stanley has an axe to pay in 10 years. Right now, the firm might call JP Morgan, Citibank and Chase and ask them where they would receive in 10 years. SwapsWire would cut to the chase without involving AT&T. "There would be a series of elecronically facilitated bilateral contacts between Morgan Stanley and the dealer group, in that instance—or we could contact a broker through the system,” says George James, managing director and head of global derivatives and government bonds at Morgan Stanley Dean Witter. Dealers could ask for indications of interest or live bids, and transactions would be processed electronically. The consortium hasn't yet determined a fee structure for those on the system.
For dealers, the advantage of Swaps-Wire is that it will be a standardized, straight-through-processing system. In this regard, the consortium is in a tidy position, since FpML, the XML-based language JP Morgan is developing with other large broker-dealers (see "XML To the Rescue,” Page 33), will have jumped through myriad hoops of consensus and approval by the time it's unveiled and put to work in SwapsWire. The potential for straight-through processing—currently an impossibility—would clearly mitigate middle-office and back-office headaches, improving settlement along the way and trimming the cost base of vanilla products and interest rate options.
Reluctant to limit its scope too soon, however, SwapsWire has also announced its intent to invite large corporate users onto the system at some point. Here, though, there's a potential clash—or at least disconnect—between the needs of corporate users and the interests of dealers. Corporate treasurers, naturally, are interested in getting the best price on a swap. They need quotes that are simultaneous and dealable—and from the perspective of end-users, an auction is the cleanest way to accomplish that. But Swaps-Wire won't be going that route. "We will only do bilateral transactions—that's firm,” says James. "We're not an exchange or auction mechanism. This is not eBay.”
Straight-through processing is a good and fine target, notes one market participant, but "if SwapsWire is just another quoting service, then I'm not sure there's a lot of advantage to that.” Of course, for corporates with relationships with the various SwapsWire partners, getting bids would be simpler electronically than by phone. But SwapsWire isn't going to convert itself into a trading vehicle—and that's what many treasurers are hankering after.
There is also rampant skepticism about the likelihood of SwapsWire partners to pursue anything that would require them to become more competitive with one another. Tight spreads are cutting into trading profits, and electronic trading would only make things worse. In addition, even though some brokers may venture aboard the site, a prime advantage of the system for dealers is that it will disintermediate the brokerage business and save them in fees. Brokers, after all, aren't in the business of helping corporates get swaps, and if SwapsWire starts out as an interbank site (or largely so), it will wind up reducing brokerage business—no matter what its partners say.
TreasuryConnect is taking a different tack to electrifying the swaps market. Indeed, its name serves as its calling card. It's a system designed, in brief, to allow end-users to communicate and trade with dealers, notes Bruce Usher, president and cofounder of TreasuryConnect. So far, the system is scheduled to play host to more than a dozen dealers that have promised to offer execution.
|Treasurers have trouble getting quotes that are simultaneous, so they end up pursuing moving targets when making decisions on price.
While the interdealer interest rate market is huge, TreasuryConnect's focus is on the corporate treasury market—which is also sizeable at, roughly, a few hundred swaps per day. TreasuryConnect is consequently tailoring its offerings to meet its core customers' needs.
To be sure, while spreads have already withered and shrunk, the needs of corporate users aren't currently being met efficiently in the phone-centric world of interest rate and currency swaps. A fundamental problem is that treasurers have trouble getting quotes that are simultaneous, so they end up pursuing moving targets when making decisions on price. They also need bids that are dealable and competitive.
When it launches, TreasuryConnect will offer customers a few options for getting bids. A corporate could get an indication or a dealable price quote, or it could opt for a closed or open auction. To receive a bid, the customer fills out a term sheet electronically and solicits pricing from any number of dealers on the site. The closed auction is designed to mimic the current telephone process. Dealers come back with a price or rate, without knowing what other dealers are offering, and the customer chooses a counterparty. In an open auction, dealers will be able to see each other's bids—they won't know who they're competing against, but they'll see the rates other dealers are providing, and they can change their rates at any time until the customer hits one of them and does the deal.
The big efficiencies with TreasuryConnect are in the area of straight-through processing, argues Usher. But one hurdle is standardizing the term sheet. TreasuryConnect says it has talked with dozens of swaps customers to fine-tune the term sheet, but swaps are customized instruments and there's bound to be some heartache in this area. And with no common language like FpML supporting the system, TreasuryConnect must set up interfaces with all customers and dealers playing on its swing set—no mean task. Still, the firm says it's prepared to do this. The system's development team came from ADS Associates, via SunGard, and the system is being set up to connect to SunGard's Network Trade Model, an XML-based application interface technology. All this, of course, signals yet another convergence of over-the-counter trading and risk management applications that should ultimately benefit end-users of derivatives.
TreasuryConnect, which was scheduled to be in pilot testing this month and planned to start executing swaps sometime next month, will transact U.S. dollar and cross-currency swaps, including callable and amortizing swaps, and caps, floors and collars. It's not designed to handle highly customized transactions such as tax-driven structures, says the company. TreasuryConnect will not charge customers to use its system; instead, the winning swaps dealers will pay a fee on a declining scale that starts at 1/10 of a basis point and, for larger notional sizes, declines to as low as 1/100 of a basis point.
The corporate treasury interest rate market, however, is not the final destination for TreasuryConnect. The firm, which has seed money from Williams Capital Group and is being financed by Enron Investment Partners and AIG Financial Products, acknowledges that interest rate swaps are the first layer in what is likely to be a wider offering of derivatives instruments. "A lot of the work in building this system is in getting the connectivity and straight-through processing functional,” says Usher. "Having accomplished that, it will then be increasingly easy to add other products to the pipeline, so there is an objective to do that.” There's also an objective, he adds, to move outside the United States, to Europe and Asia.
JP Morgan Jumps Into Back-Office Processing
JP Morgan, the firm that spun off its risk management models into The Riskmetrics Group and its front-office trading technology into Cygnifi, now seems to be aiming for the back office.
The latest JP Morgan spin-off is Arcordia, an Internet back-office-processing venture set up as a partnership with database powerhouse EDS to provide 24-hour access to an Internet-based management and settlement system for a variety of derivatives products. Functionality currently includes all interest rate and credit derivatives, including the complex exotic varieties. By the end of the quarter, equity derivative products will also be on-line, and accounting and confirmation of all underlying securities is planned for next year.
"Our goal is to provide one platform to handle products that historically have been processed on a variety of different systems,” says Rafic Dahan, CEO of the new venture, in which JP Morgan owns a 90 percent stake. "We will handle trade capture, all cash flows on a netted basis across product, and the entire confirmation process. There will be transaction management and accounting with much less human interface than exists in the typical back office today.”
Dahan's hope is that bank and client back offices that need to redesign their derivatives support systems will outsource to Arcordia rather than go it alone at a prohibitive potential expense. "Banks are looking at costs between $75 million and $125 million per product line to bring systems up to par with current product offerings. With Arcordia, they will simply pay a price per transaction—'services by the drink,' so to speak. They will take advantage of four years of development already made by Morgan.” In other words, don't reinvent the wheel if someone has already spent a great deal of money doing so—just grab hold of someone else's hard work. Arcordia stands ready to serve.
The system is based on a component architecture so that banks can "plug and play” whichever products they want handled. The system may be manned by either a bank's own staff or completely outsourced to private-labeled Arcordia personnel. Either way, the system will provide its operational reports and cash-flow statements to outside clients from the client's perspective, netted across all products—a combined functionality that is perhaps the system's strongest selling point.
Internet-based software platforms are a potential new source of profitability for banks like Morgan. For the moment, Arcordia has just one client—Morgan itself. But as more and more trading is done electronically, the firm could serve as a natural back-office service provider for Internet ventures like Swapswire.com or Brokertec.com.
At the moment, however, Arcordia will have to overcome some significant market hurdles. First, Arcordia.com may be trying to split the functions of a traditional back office in a somewhat artificial manner. The system specifically does not include such traditional back-office duties as credit monitoring or calculating client margin. Arcordia also stops well short of any risk management capabilities to analyze derivatives books for the front office. If a firm is interested in theta, vega, gamma, delta or overall value-at-risk exposure, that type of information will still need to be computed at the bank level. Even the mark-to-market process will emanate from the individual bank client and be downloaded to Arcordia for position valuation and accounting purposes.
Dahan believes that the firm's service must be structured this way because every bank customer will want to look at its risk differently. "The system is specifically separate from the risk management engines,” he says. "We want to provide services that are nonproprietary in nature, and leave the banks to take our transactional information and use it as they see fit.”
Is Arcordia's approach to functionality sufficient and appropriate enough to attract interest from other banks? If the cost and effort of interfacing Arcordia to bank risk systems is sufficiently low, then Arcordia's pay-per-trade approach may revolutionize back-office derivatives processing. If not, or if another Internet-based system comes along that provides more soup-to-nuts margining, credit, and risk management functions as well, Arcordia might flounder.
In any event, Arcordia's average sales process is likely to be a long one. Banks have built up a tremendous number of front-end and back-end systems over the past 10 years, at considerable cost. The decision to scrap some part of that expense will likely come only from the most senior levels of management. "We are not setting out to convince people they have to change,” Dahan admits. "But once these banks or other clients have recognized that they need to change, we want to be there with a cheaper, faster alternative solution for them.”
For more information, see www.arcordia.com.
Morgan Announces Credit Trading Site
In the online battle for credit derivatives' market share, JP Morgan has been a vocal—and financial—supporter of CreditEx (www. creditex.com), which has been duking it out with London rival Credittrade (www.credittrade.com) for the last year. End-users—the great untapped market in credit derivatives—have been slow to embrace either.
Now, Morgan is stepping out on its own. The credit derivatives giant last month launched a new site, Morgancredit (www. morgancredit.com), to trade credit derivatives online. Whereas other online sites provide direct two-way trading, Morgancredit is offered only to JP Morgan clients.
The site offers live two-way credit derivative prices on hundreds of North American, European and Asian credits, and facilitates trading by providing direct telephone links to trading desks. The site hopes to create the first transparent forward curve for credit risk by featuring two-way prices for three-, five-, seven- and ten-year maturities. It offers previously unavailable data on spot and historical credit swap spreads for individual credits, as well as credits sorted by industry and geography. It also provides a library of research and educational material, and market commentary by the firm's local credit derivative teams in London, Tokyo and New York.
"The Internet gives us an extraordinary tool to promote liquidity and transparency in global credit markets,” says Blythe Masters, managing director and head of North American structured-finance and global credit derivatives marketing. "This benefits dealers and end-users equally and is our primary and permanent objective.”
The site provides an advantage over traditional voice and Internet brokerages, says Morgan. Because it is acting as principal, it eliminates the intermediary step of matching client trades, protecting client anonymity and significantly reducing the time to close a transaction.
Agreement Defines Cross-Product Netting
In the last decade or so, financial institutions have forged agreements permitting netting different instruments within a single asset class in the event of bankruptcy. But what happens when more than one asset class is involved?
In February, industry associations banded together to help confront the problem. The Bond Market Association, the British Bankers' Association, the Emerging Markets Traders Association, the Foreign Exchange Committee, the International Primary Market Association, the International Swaps and Derivatives Association, the Investment Dealers Association of Canada, the Japan Securities Dealers Association and the London Investment Banking Association joined forces to release the Cross-Product Master Agreement, to help keep the anxiety of August 1998 at bay.
The CPMA is designed to cover situations in which one firm has a range of financial contracts with another firm. This umbrella netting agreement, its authors believe, will facilitate the parties' ability to assess their overall exposure and reduce the possibility of systemic risk if a major market participant were unable to meet its obligations. In its report, the group cited the industry's development of a standardized cross-product master agreement as a way to reduce the risks through the availability of a cross-default and pre-emption of certain notice periods in the event of a default under the CPMA.
The agreement includes three major operational steps. First, the occurrence of a close-out event under one principal agreement permits the close-out of all (and not fewer than all) principal agreements. Second, settlement amounts are determined according to the terms of each closed-out agreement. Third, those settlement amounts are themselves set off to obtain a single final net settlement amount due.
"By applying the Cross-Product Master Agreement,” said Paul Saltzman, executive vice president and general counsel at the BMA, "the financial markets will have a contractual superstructure covering a spectrum of financial products that will provide greater legal certainty, reducing risks and enhancing liquidity in global markets. The document will create a standardized umbrella agreement that is as simple as possible given the inherently complex nature of the issues.”
For a copy of the CPMA and its attending definitions, see www.bondmarkets.com.
Oil and Metals Dealers Unite On-line
Like many of their over-the-counter siblings, oil and precious metals derivatives may soon be heading for the ether. Last month Morgan Stanley Dean Witter, Royal Dutch/Shell Group and five other heavyweights announced the creation of IntercontinentalExchange, an Internet-based platform for OTC trading in the oil and precious metals markets.
The IE will start out with petroleum and precious metals instruments and will follow up later with natural gas, power and other commodities. The new system is slated to trade forwards, swaps and options when it launches later this year.
Current participants in the IE are BP Amoco, Deutsche Bank, Goldman Sachs, MSDW, Royal Dutch/Shell Group, Societe Generale Investment Banking and Totalfina Elf Group. "We were able to get these fierce competitors in oil and metals...the Number 1, 2 or 3 market-maker in each of the contracts we intend to launch,” said Jeff Sprecher, CEO of the platform, in an interview with the Associated Press. "They made very, very large volume commitments.” Sprecher is the former president of Continental Power Exchange, an electronic electricity exchange whose technology and assets the partner firms are buying.
OTC derivatives trading in commodities has to date been restricted to telephone-based trading networks. This platform, however, will enable firms to trade products electronically. This is expected to result in real-time quotes, improved liquidity and more transparent markets. The IC will use the extreme clustering technology of Beaverton, Ore.-based GemStone Systems as the foundation of the new platform's architecture.
…And So Do Gas and Power
The energy industry has another prospective on-line darling. Six large natural gas and electricity marketers in the United States last month announced they had formed a consortium that would own and operate an Internet-based energy trading system for North American utilities and other large companies. The as-yet-unnamed system is expected to be up and running by the end of the year.
|Last year, 2 percent of natural gas trading and 0.2 percent of electricity trading occurred on-line. Those numbers are expected to rise to 25 percent and 11 percent, respectively, by 2004.
"This Internet platform initially will offer an over-the-counter market place for natural gas and electricity in North America,” said Paul Addis, president of AEP Energy Services, in a joint statement issued by the consortium. "But we expect to expand our business to include natural gas liquids, coal, weather derivatives, crude oil and other energy-related commodities and instruments as those markets develop.” The consortium includes American Electric Power Co.; Aquila Energy, a subsidiary of UtiliCrop United Inc.; Duke Energy Corp., El Paso Energy Corp.; Reliant Energy Inc; and Southern Co. Energy Marketing, a unit of Southern Co.
According to Ed Mills, president of Aquila Energy, the platform will be open and independent. "This will allow the platform to provide the real-time price and data discovery that's often missing in current trading systems,” he noted. "We expect other benefits will include enhanced liquidity, faster market execution and considerably lower transaction costs.” Insufficient liquidity, price discovery and transparency in the energy markets prompted the consortium members to put their heads together to consolidate trading.
Last year, 2 percent of natural gas trading and 0.2 percent of electricity trading occurred on-line, according to Forrester Research. Those numbers are expected to rise to 25 percent and 11 percent, respectively, by 2004. The six energy companies in question were responsible for more than one-third of last year's total electricity trading in the United States, and more than 25 percent of the year's natural gas trading. The consortium is currently in talks with potential trading technology partners.
Derivatives Litigation Box Scores On-Line
By Nina Mehta
What most people outside finance know about derivatives is that they detonate regularly, leaving financial disasters and a string of lawsuits in their wake. Think Orange County. Sumitomo. Gibson's Greetings. Now, courtesy of PricewaterhouseCoopers, it's possible to put some statistics behind those suspicions.
In February, the firm released a study of derivatives litigation since 1994. The report, which identified 310 federal court actions involving derivatives from January 1994 through September 1999, found that derivatives litigation "tends to increase in times when the markets are volatile.” The largest number of derivatives cases filed in U.S. federal courts and the largest number of federal enforcement actions occurred in 1994 (34 cases filed and 27 enforcement actions), after a period of rising interest rates. The study also found a flowering of cases after the 1997 Asian crisis and the 1998 Russian crisis.
If this link between market volatility and litigation persists, derivatives on volatile Internet stocks and indices are likely to be the basis for litigation in the future. The study suggests that on-line foreign exchange and over-the-counter derivatives trading could also yield more than a few litigation headlines in the future. "As trading becomes more popular and inexpensive,” speculates John Finnerty, a PwC partner and the study's author, "it seems likely that legal issues such as jurisdiction will increase regulatory activity and that inexperienced investors will be drawn to derivatives, increasing the probability of litigation.”
Total cases by derivatives instrument type—1994 through the first three quarters of 1999
Highlights from the study include the following:
- OTC derivatives represented 76 percent of all litigation cases from the first quarter of 1994 through the third quarter of 1999. The remaining cases involved listed instruments.
- Futures and forwards accounted for 31 percent of derivatives litigation. Options were involved in 21 percent and collateralized mortgage obligations in 17 percent of derivatives litigation in that period.
- Interest rate-related cases were more common from 1994 to 1996 than they are now, mainly because of earlier interest rate volatility that "led to some substantial derivatives investment and trading losses.”
- The underlying security that has had the most success at attracting derivatives litigation has been commodities, which accounted for 28 percent of the total number of cases. Derivatives based on mortgage-backed securities accounted for 22 percent of litigation cases; interest rates, 18 percent; currency and equity, 11 percent each; and bonds and Treasuries, 7 percent.
- Commodity derivatives currently remain the products most likely to be involved in derivatives litigation. Equity derivatives, the runner-up, are involved in less than half as many cases as commodity derivatives, although their contribution to litigation is on the rise (from three cases in 1994 to 11 in the first three quarters of 1999).
- Most of the derivatives cases (24 percent) included in this study alleged securities fraud. Breach of fiduciary duty, fraud and negligent misrepresentation each kicked in about 20 percent of the total allegations of misconduct.
- Nasdaq and the Chicago Mercantile Exchange have been involved in the highest number of derivatives litigation cases.
PwC's study, which is available on its recently launched derivatives litigation web site, will be updated quarterly. The derivatives litigation database, underlying case data and updates are also available on the site. For more information, see www.pwcderivatives.com.
FASB Keeps Tinkering
When the Financial Accounting Standards Board released its latest exposure draft on Financial Accounting Standard 133, corporate treasurers and accounting firms hoped that it would finally shed some meaningful light onto how to interpret the often confusing accounting rule.
But instead of clearing things up, the draft set off another round of controversy. This time, triple-A institutions were the aggrieved parties. The draft said that swaps based on double-A-rated benchmarks like the London Interbank Offered Rate can't be used to hedge interest rate risk in triple-A-rated instruments—but can be used to hedge the overall fair value of the item.
|FASB's new rule is akin to allowing the use of toothpaste for any purpose other than brushing one's teeth.
A coterie of triple-A institutions, including the Inter American Development Bank, Fannie Mae, Freddie Mac and the Federal Home Loan Bank System, objected publicly to the rule. "We believe that the triple-A instrument restriction in the draft standard unfairly penalizes issuers of and investors in triple-A-rated financial instruments,” said Gregory Reynolds, corporate controller at Freddie Mac, in a comment letter to the FASB. An executive at the Federal Home Loan Bank System of Boston, meanwhile, said the exposure draft places triple-A issuers and investors at an "unfair disadvantage.”
Many of the firms that responded to the draft argued that their main rationale for using Libor-based swaps was to hedge interest rate risk—rather than the overall fair value of the underlying instrument. They argue, essentially, that FASB's new rule is akin to allowing the use of toothpaste for any purpose other than brushing one's teeth.
The initial uproar caused FASB to backpedal almost immediately. "We will absolutely redeliberate all of the issues in the document,” said Tim Lucas, FASB's director of research and technical activities, "and this one has been prominently brought up in a number of the comments.”
Interest-rate risk wasn't the only controversial issue in the draft. Its refusal to grandfather in intracompany hedges entered into before 1999 angered many, including the Bond Market Association, the International Swaps and Derivatives Association and various financial institutions and corporates. David Sidwell, a managing director and comptroller at JP Morgan, wrote of his disappointment over the decision, "since this is one of the most potentially costly and operationally burdensome issues we are facing.”
ISDA, meanwhile, said many of its constituency face a "significant reporting burden and costly exercise to try to match up pre-1999 intra- and intercompany contracts executed for loan and funding books with third party contracts in the trading account.” Some of those, noted ISDA, are long-term in nature and would in some cases require new contracts to be written. "Having to match up old contracts in this manner will be a costly exercise and add more credit risk to the market as financial institutions have to execute contracts with outside dealers.”
Such reactions are nothing new in the peculiar history of FAS 133. The board is expected to issue a final draft of Statement 133 by June 1. But whether anyone will understand it—much less support it—is still anyone's guess.
|Now in English
The Fall of UBS, Dirk Schutz's account of the back-room machinations that led to the collapse of Switzerland's biggest bank, has finally been translated into English. Two chapters about the role of Ramy Goldstein appeared in Derivatives Strategy (October 1998). It is available from on-line booksellers or by calling 800-626-4330.