A regulatory overhaul of the $600 trillion market for privately traded derivatives, or swaps, is forcing dealer banks and brokers to rethink their business strategies, with some considering an agency model, drawing on its popularity in the futures market.
The 2010 Dodd-Frank financial market law and similar policy developments in other jurisdictions will require that certain standardized and actively traded swaps be executed on open platforms and routed through central clearinghouses that guarantee trades, much like exchange-traded futures.
Those new rules will force swaps dealers to compete harder than ever before, and accompanying transparency and trade-reporting requirements are expected to give end users of swaps more bargaining power, making for thinner profits among market-making dealers and their brokers.
Moreover, new margin requirements will encourage a move away from exotic trades, and more transactions will be conducted electronically over exchange-like venues, bringing more automation to the business.
As swaps migrate onto screens, the significance of a client's relationship with a dealer will diminish, and dealers will be forced to offer clients more value. Some believe that having an agency desk to help customers access sources of liquidity as trading becomes fragmented will be one way to improve the flow of client orders.
"One by one, here and there, regulatory unknowns are being replaced by rays of light -- an agency brokerage model for swaps is among the first responses to take shape," TABB Group senior analyst Paul Rowady said in a report Thursday. "Core dealers in these markets can do nothing, quit, or reinvent the game."
UBS (UBS) is one dealer developing such an agency model for swaps, leveraging off its technology and infrastructure in futures and equities. The idea is that customers place orders with their preferred dealers, who execute the orders with whichever swap execution facility, or SEF, has the best terms.
In some cases, the customer may meet UBS in a trade, but not in all, and in any event this approach gives the dealer a way to continue its relationship with that customer while layering on top its post-trade processing, research and other services.
Additionally, customers will not have to worry about connecting to every trading venue created, which could be costly and complicated, because their dealers will already have connectivity to those sources of liquidity.
TABB estimates there could be as many as 40 different swap trading venues to start, whittling down to at least three or four SEFs per asset class as the market matures.
"There's no question agency will be a more efficient way for customers to trade," said Paul Hamill, executive director in global credit trading at UBS, in an interview Thursday. "This model allows us to use our existing infrastructure to insulate customers from costs, whilst protecting their access to liquidity."
Roughly two-thirds of the swaps market is expected to be covered by the Dodd-Frank mandate that standardized swaps with a certain amount of volume will have to be cleared and traded on open platforms.
But some believe it is too early to say if an agency model will develop for swaps in the way it has for the futures market. For one thing, it will depend on the volume of trades going over those SEFs, and swap market liquidity can often be very light, with some of the most active contracts trading only 20 times a day.
Outside of the dealer community, inter-dealer brokers -- which match trades between banks -- are also looking at changes, including an agency model of their own.
Mickey Gooch, chief executive of GFI Group (GFIG), said at a swap conference in September that the broker may not elect to apply as a swap execution facility in every asset class. For one thing, he said, the firm does not see as much business in currency swaps as other instruments. But he said GFI would be interested in fronting customer order flow in currency swaps and putting the orders into someone's else's liquidity pool, or SEF.
One problem for inter-dealer brokers is that they are not yet set up to serve regular customers like asset managers and hedge funds, only dealer banks. They would first would have to put documentation in place with customers, and connect them to their execution platforms.
Furthermore, dealers don't want to see their brokers pursuing end-customer business, because dealers make their money off the spread between where trades are priced in the wholesale market among dealers, and what they can charge customers on a separate pricing tier.
"The interdealer brokers will start opening up access to clients and can start to compete directly with dealers," said Kevin McPartland, director in fixed-income research at TABB Group in New York.
Some believe this development would be a stretch for brokers, however.
"Could a non-SEF introduce a client into a SEF liquidity pool? Yes, it seems like this should be possible," said Sonali Das Theisen, director, global credit trading at Barclays Capital.
"But the spirit of Dodd Frank is open access," she added, "so it is likely that over time if the client becomes an active participant in the product, that the client would probably find a way to access the liquidity directly."
-By Katy Burne, Dow Jones Newswires; 212-416-3084; email@example.com