Electronic trading
Inter-dealer brokers are competing fiercely for market share in electronic credit default swap trading before an inevitable rationalization in the New Year.
Following Creditex’s lead, GFI, Prebon Global Credit, and ICAP have all launched electronic CDS trading platforms this year. If others follow suit, half a dozen platforms could be live by early 2005.
“Screens really do encourage people to trade, especially index trades,” says Simon Mayes, a CDS trader at Lehman Brothers in London. “Volumes traded now are significantly larger than nine months ago when we had just voice broking. They encourage trades because you are one click away from pulling a price off the screen. That’s an important development. When people know that they haven’t always got that last chance to trade a price, it does push them to trade and to pay that extra basis point.”
Perfect timing
In February, Creditex launched its electronic credit derivatives trading platform Creditex RealTime. It combines order entry and management, automatic trade execution, real-time market data, and trade confirmation (although some dealers still re-enter their trades manually). According to research by Boston-based Celent Communications, by July Creditex had captured about 25% of the index trading market.
“Creditex was able to steal the market,” says Celent analyst Adam Josephson. “Its timing was perfect. It had no index business before it launched the platform but it was able to garner a sizeable portion of the index trading market and it still has that, despite the competing platforms.”
Those include GFI’s CreditMatch, which went live in August. Banks using CreditMatch that month included Barclays Capital, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Lehman Brothers, and Merrill Lynch. In September, trading of European indices and single names started on Prebon’s platform, PrebonEdge. Credit derivatives trading on ICAP’s BrokerTec platform kicked off on November 1.
Creditex has certainly made the most of its first-move advantage. It says that RealTime has handled well over $100 billion of trades since launch. “Other brokers’ volumes were seriously impacted by Creditex,” says Mayes. “They have responded.” Mayes, who trades CDS written on financial names, has Creditex’s, GFI’s, and BrokerTec’s platforms on his desktop.
The question now, with these three screens rapidly becoming the standard, is how can other brokers break in? And can they survive? Traders can only look at so many screens. If the FX markets are a guide, by the middle of next year two, or at most three, screens will have become established in the market. For inter-dealer brokers, the stakes are high. One trader expects the number of brokers to fall in 2005. “In a year, there’ll be a maximum of five,” he says.
That’s because while some credit derivatives products lend themselves to electronic trading, structured products will always be voice-brokered. More volatile markets will also favour voice-electronic hybrid brokers.
“The lower spreads of the last year have facilitated the move to electronic trading,” says Michel Everaert, global head of sales and marketing at GFI. “But when it really becomes important to trade quickly, you need both screen and voice-broker support.”
“Electronic systems don’t necessarily afford best price discovery in all products,” says Gary Smith, managing director of Garban Securities.
“Creditex will keep attracting a reasonable amount of liquidity,” says Celent’s Josephson. “And GFI and ICAP have sizeable credit derivatives businesses and simple, easy to use platforms familiar from other markets. Many credit derivatives traders have come from other desks.”
ICAP has added credit derivatives to BrokerTec’s electronic fixed-income platforms, which operate alongside ICAP’s voice-broking business. ICAP bought BrokerTec in May 2003. Building credit derivatives trading onto existing platforms need not be a handicap if the platform is robust.
Volumes traded on ICAP’s electronic platforms reached a record $45.9 trillion in the third quarter of 2004. Electronic volume in US treasuries was up 59% on the same period last year and ICAP estimated its combined voice and electronic market share in US treasuries at 58%.
“You can’t have such high market shares in products like US treasuries on a platform that isn’t stable,” says Smith.
“Creditex still has the best platform technology-wise,” says Rupesh Tailor, a CDS trader at Barclays Capital. “I don’t think anyone’s gone beyond what they’ve got, and they have good technical people, so if they need to innovate they should be capable of doing so.” That capability will be the key to capturing and keeping liquidity.
The later arrivals, like Prebon, face a bigger challenge. They don’t have the underlying liquidity in voice-brokered credit derivatives that gives such providers as GFI and ICAP a head start. Prebon only re-entered the credit derivatives market in February.
They will also find it harder to tack electronic credit derivatives trading onto existing platforms. Prebon is a major energy broker. PrebonEdge is based on technology from trading systems provider Trayport. Trayport’s Global Vision technology is used as standard in the European oil and gas markets. That doesn’t mean it translates well to credit derivatives trading. “No other firm has used this platform,” says Josephson.
“Our energy guys use Trayport and it was one of the systems we started to look at,” says Everaert. “But we felt that the CDS market required a more dedicated approach.”
Certain growth
Electronic trading of credit derivatives is certain to grow. “Volumes now are not nearly where they’re going to be, and the market’s ability to sustain its growth depends on the ease with which it can process transactions,” says Josephson.
Leading dealers have devised a three-year strategy to promote automation and straight-through processing (STP), while the International Swaps and Derivatives Association (ISDA) wants to see cashflow matching on all OTC product classes by December 2005, and cross-product netting and daily portfolio reconciliation by December 2006. Although some dealers say this is ambitious, Josephson points out that many firms are already using back-office matching services and STP systems from such providers DTCC and SwapsWire.
“Generic STP is not in place yet, but it is definitely the future,” says Everaert.
The most important catalyst for a high-volume market will come when large dealers build automated pricing engines and link them to the inter-dealer platforms. Celent predicts these engines will be built by late 2005 or early 2006. “They will facilitate trading,” says Josephson. “They will free traders from having to deal with more arcane pricing matters. The absence of pricing engines limits the amount of activity that can take place in a given day.”
So while Celent thinks that nearly 50% of index trades will be placed electronically by 2007, single-name CDS will not be traded electronically “to a significant degree” until early 2006.
Still, market share is worth fighting for. Electronic trading is a small portion of a rapidly growing market. According to the British Bankers’ Association, the notional outstanding volume of the global credit derivatives market will be $8.2 trillion by 2006. And electronic trading technology can boost voice-broking activity. A trader with live, tradeable prices on his screen can still pick up the phone to a broker. “I do not care if people trade electronically or by voice as long as the trade comes through GFI and not someone else,” says Everaert.
