From the June 01, 2012 issue of Futures Magazine • Subscribe!

Why the swaps market will follow the repo model

The repo market today

The repo market has changed significantly over the last 15 years. It is still OTC and there is still no exchange, but many of the barriers to entry are gone. As the barriers fell, more participants entered the market. Volume and efficiency increased, it became electronic and spreads narrowed. With the elimination of inter-dealer credit risk and balance sheet usage, dealers worked for smaller spreads. Bid/offer spreads were 25 basis points in the early 1980s, 10 basis points in the 1990s and are between 1 and 3 basis points today. To compete today, a dealer must run a book of business by matching client long and short positions, making markets and taking risks.

Becoming a dealer is easy. Trading on the brokers’ screens only requires FICC membership. Membership means one counterparty, one legal agreement, one margin payment and only net securities deliveries. As a member, a bank or broker-dealer has no counterparty risk or balance sheet implications from trading with other dealers. 

The dealer community no longer controls access and there are no hierarchical rules. The IDB brokers are principal for the on-leg of the trade, so other dealers are blind to who is trading. Most of the market trades electronically. The dominant IDB is BrokerTec, which trades more than 50% of the daily volume. Overall, the repo market is now liquid, electronic and efficient. 

The swaps market was nonexistent 30 years ago and since has grown to be seven times larger than the futures market. Today’s swaps market is similar to the repo market before FICC. It is OTC, name “give-up” and has significant barriers to entry. Institutions need credit lines, ISDA agreements and acceptance by other dealers to trade in the brokers’ markets. 

The market operates under the dealer-customer model. Dealers are market makers and trade through IDB brokers. Only dealers can trade on the broker screens, which are all “voice brokers.”  The brokers control price dissemination, access and liquidity. There is no electronic interest rate swaps broker. Prices are published, but the “inside” market is only available in the IDB shops. This practice secures an “inside” market for the dealers. 

The “business” of interest rate swaps is similar to the repo business. Swaps dealers must run a “book” of business and act as a market maker to generate sufficient returns. There’s a large divide between the first and second tier in the market. The largest bank dealers have the significant franchises. They “own” the market because they have the capital, credit ratings and customer flow. Their business is highly profitable and they seek to protect their market and preserve profitability. Not surprisingly, the dealer community resisted exchange trading and CCP.

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