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Worries are mounting over trades and counterparty risk in the OTC derivatives markets. New trading systems could help make things safer.

Mnvestors in the credit markets have grown accustomed to systemic dislocations every few years, the 1994 Latin American debt crisis and the 1998 Russian default being among the most recent and spectacular. The first few months of 2005 have once again seen roiled markets, as formerly blue-chip automakers General Motors Corp. and Ford Motor Co. had their huge debts downgraded by Standard & Poor's to junk status, sending risk premiums on all manner of credit investments skyrocketing.

Derivatives based on credit and interest rate instruments have been particularly volatile. Premiums on Dow Jones's benchmark index of investment-grade credit default swaps ballooned from 59 basis points in mid-April to 77 basis points in mid-May before tightening to 54 basis points in early August, according to financial information firm Markit Group. Likewise, the spread on Dow Jones's high-yield credit default swap index grew from 4.59 percent in mid-April to a high of 5.18 percent in mid-May before falling back to 3.65 percent at the beginning of August.

"It has been busy for everyone," says Peter Wilson, senior portfolio manager at San Francisco­based Barclays Global Investors, which has $1.4 trillion under management. "There's no shortage of news events in the credit markets right now."

Responding to these events is another matter. Despite the need for quick decision making and hair-trigger execution, dealers and investors in the over-the-counter derivatives markets continue to be held back by outdated processes for making transactions. Many trades are initiated by scribbling instructions on paper tickets. Phone conversations and faxes instruct dealers on how to allocate pieces of a trade to various client accounts. Credit derivatives dealers must pore over customized stipulations in complex, nonstandardized contracts so that they thoroughly understand what they're trading. Contrast that with the cash equities markets, where tens of thousands of shares change hands every second with little more than the click of a mouse.

It's an ironic turn of events for derivatives professionals: One of the youngest markets is hampered by old-fashioned systems and technology. And rapid growth in derivatives markets is only exacerbating the paperwork burden. The credit default swaps market mushroomed from $631 billion in notional principal outstanding in mid-2001 to $8.4 trillion at the end of 2004, according to the International Swaps and Derivatives Association (ISDA). That hypercharged expansion has the U.K. Financial Services Authority so worried about dealers' ability to process trades that in February the agency publicly admonished firms to beef up their back offices.

"We are concerned about the level of unsigned confirmations, with some transactions remaining unconfirmed for months," wrote former FSA capital markets sector leader Gay Huey Evans (who now runs the European operations at Citigroup's Tribeca Global Management hedge fund unit) to dealers at that time.

The FSA's concerns were underscored in late July by the Counterparty Risk Management Policy Group, an association of industry executives who are studying ways to strengthen the global financial system against potential shocks. In a lengthy report the group recommended the adoption of electronic trading, among other steps. Advocating that OTC derivatives intermediaries, particularly in the fast-growing credit default swaps market, "take part in and strongly encourage the development of electronic trade matching and confirmation generation systems," the report called the growing backlog of unconfirmed trades "a matter of urgency."

Automating trades among a wide array of dealers and customers would make it easier to implement straight-through processing for these instruments, as well as improve price transparency for investors and make quote dissemination more efficient for dealers. It also stands to reduce errors and tighten bid-ask spreads, boosting volume and liquidity.

So far, however, electronic trading in the OTC derivatives markets has been limited mostly to systems in which dealers trade highly liquid, standardized instruments among themselves. In credit derivatives there is New York­based Creditex and two systems owned by London-based interdealer brokerages: GFI Group's CreditMatch and BrokerTec, run by ICAP (see table). For interest rate swaps there are platforms such as Charlotte, North Carolina­based Blackbird -- which also trades currency swaps and offers dealer-to-client trading -- and ICAP's ISwap. London-based bond-dealing network EuroMTS plans to launch an interdealer swaps platform in the second quarter of 2006. Financial information giant Reuters has offered an interdealer platform, Reuters Matching for Interest Rates, since the spring of 2004.

Despite the promise of greater benefits for all OTC derivatives market participants, automated systems that would allow trading among a wide array of customers and multiple dealers are rare. That's mostly because customers historically have traded far less frequently than dealers and often required transactions to be customized to their needs. Electronic systems aren't the ideal venue for executing such trades. Indeed, several companies have tried but failed to build dealer-to-customer platforms in recent years, including TreasuryConnect and

"You cannot just 'build it and they will come' in these markets," says Simon Wilson-Taylor, global head of State Street Corp.'s Global Link, a multibank dealer-to-customer system that offers execution in the foreign exchange, futures and equity markets -- where customers trade frequently -- but not in OTC derivatives. "A corporate buying a currency option, for example, wouldn't be buying hundreds of them a day. If they only buy one a week, they aren't going to be very comfortable using a system to buy it. It's better to have a conversation."

Moreover, big banks don't feel the same pressure to automate their handsomely profitable derivatives operations that they do in cash equities, where revenues and profit margins have been shrinking for years.

"The volumes are lower, and the margins you make as a broker are higher," says Dushyant Shahrawat, a senior analyst at TowerGroup, a financial technology research firm in Needham, Massachusetts. "So what's your motivation to spend money on automating the process? Fairly slim."

The status quo may be about to change, however.

One big reason: Nonbanks -- particularly hedge funds -- are becoming more active traders. "Among the biggest customers of the banks are hedge funds, and the volumes they trade rival the volumes banks have with other dealer banks," says Robert Pickel, chief executive of ISDA. "Hedge funds are increasingly sophisticated and have systems in place that can take advantage of the efficiencies generated through greater use of electronic trading."

Additionally, the markets for interest rate swaps and for instruments based on indexes of credit default swaps have grown rapidly. ISDA estimates that notional principal outstanding for interest rate swaps, options and cross-currency interest rate swaps grew from $100 trillion at the end of 2002 to almost $184 trillion at the end of 2004. Index trading based on the Dow Jones CDX, TRAC-X and TRACERS indexes grew from almost $115 billion in notional principal outstanding in December 2003 to more than $737 billion in February 2005, according to Morgan Stanley estimates. Index products' relative homogeneity and liquidity, compared with more-tailored credit derivatives, makes them more suitable for electronic trading.

Most important, regulators are encouraging a higher level of automation. A greater use of computerized trading, they reason, will allow more transactions to be processed in a shorter period of time, reducing the risk that trades will fail and disrupt the market. The new Basel II capital framework being developed by global financial regulators provides incentives for institutions that automate, allowing them to put up less capital against trading activities. In 2003, ISDA called for dealers to achieve full trade automation of the major derivative asset classes by the end of 2005. It also called for banks to have systems in place to achieve cross-product matching and netting of cash flows across all OTC transactions by 2006 -- a goal that it sees nearing fulfillment as vendors like Creditex spin-off T-Zero offer automated derivatives back-office processing systems. "To the extent that you have these middle- and back-office processes more automated," says ISDA's Pickel, "it will increase the logic and efficiencies of moving more and more trades to electronic front-office trading platforms."

Three New York­based companies, financial information provider Bloomberg, Thomson TradeWeb and MarketAxess, are hoping that these changed dynamics will make the market more hospitable to multibank dealer-to-customer platforms than it has been in the past. In February, Bloomberg, which had already hosted single-bank dealer-to-customer derivatives trading systems, launched its SwapTrader system. About 50 clients trade up to $40 billion per week in euro-denominated interest rate swaps with nine dealers. In March, TradeWeb, which made its name with a system for U.S. government bond trading, launched trading of euro overnight index average (Eonia) and Euribor interest rate swaps. This fall it plans to add dollar-denominated interest rate swaps to the mix. And before year-end both TradeWeb and MarketAxess will allow customers to trade credit default swap indexes.

Another potential player in the space is EuroMTS, which will consider adding interest rate swaps to its dealer-to-customer BondVision platform, but only after it has succeeded in the interbank market, according to Philippe Rakotovao, the company's deputy CEO.

TradeWeb is off to a quick start. It has signed up 35 buy-side institutions and eight dealers to provide liquidity for its interest rate swaps system, which handles about E1 billion ($1.2 billion) a day, on average, in euro-denominated swaps trades. The company also has agreements with three dealers -- Goldman, Sachs & Co., J.P. Morgan Chase & Co. and Morgan Stanley -- to provide liquidity for its pending credit default swap index system. Celent, a Boston-based research firm, estimates that 10 to 12 percent of Eonia swaps are currently traded electronically and says that the comparable figure for credit derivatives is much lower.

"We've been surprised, not by the total volume, but by the size of trades," says James Toffey, a founder and CEO of TradeWeb. "We've seen some very large swaps trades go through the platform, as big as E600 million. In other markets it takes some time for larger trades to come through."

MarketAxess has 11 dealers, including ABN Amro, Goldman Sachs, J.P. Morgan and UBS, lined up to make markets on its electronic credit default swap index trading system, which it plans to launch later this year. Company executives have been talking up the system with major buy-side investors and say that hedge funds have expressed strong interest, but they won't reveal which, if any, have committed to use it. Several institutions have helped design the system and will be part of a small launch group when the platform goes live.

"We're working with many of the largest buy-side participants in the CDS market, most of whom seem enthusiastic about the automation of the index product," says MarketAxess CEO Richard McVey. The company plans to offer trading in single-name credit default swaps at a future date.

One remaining hurdle for dealer-to-customer derivatives trading systems is ensuring the creditworthiness of unseen, anonymous counterparties. Most platforms deal with credit issues by establishing bilateral credit agreements between counterparties. For systems with a relatively small number of participants, such as the interdealer networks, that's a manageable solution. But making sure that counterparties will follow through on their commitments gets far more complex when big numbers of buy-side firms, as well as dealers, come together in a single system.

TradeWeb deals with credit issues up front, using a database to store settlement information, credit approvals and key terms from a master swap agreement that is made between dealers and the buy side when they join the system. This static information is used later to fill in ISDA trade confirmations on TradeWeb. MarketAxess will take a similar approach. Dealers will monitor credit lines and collateral documentation daily, and all trades will be electronically screened before execution for adequate counterparty credit. "The system will spit out a warning if someone tries to initiate a transaction without proper credit lines or documentation available," says Barry Goldenberg, the company's North American credit trading product manager.

How well these approaches to ensuring creditworthiness stand up over time will be a critical determinant of whether the systems ultimately succeed or fail.

"Can the new systems overcome credit issues and can they really make a request-for-quote model work in a way that appeals to users?" asks Harrell Smith, an analyst in the securities and investment group at research firm Celent and the author of a recent report on electronic trading of interest rate swaps.

PERHAPS THE BIGGEST BENEFIT OF ELECTRONIC trading -- the wider dissemination of price quotes -- accrues to investors at the expense of intermediaries. "Whenever you bring electronic trading into a market, the bid-offer spreads start to narrow because you can see what the cost is," says Barclays Global portfolio manager Wilson. Lower transaction costs can encourage investors to trade more often, boosting the market's overall liquidity. But they also sap the profit margins of dealers, who currently enjoy a lucrative information advantage in less than optimally efficient OTC derivatives markets. This reality may continue to inhibit a wider embrace of automation.

"If you are a dominant player in the market, you may have the feeling that increased transparency is not good, because you lose your information advantage," says Mazy Dar, head of electronic platforms at interdealer credit derivatives system Creditex.

Still, if derivatives markets keep growing at their current rates, what are considered exotic products today will inevitably become more standardized and therefore more suitable for electronic trading. At that point, as has happened in the cash equities business, even greedy dealers may realize that there's no escaping margin compression and that minimizing costs through automation will be the best way to keep squeezing out profits.

"There's a tipping point at which it's more cost-effective for firms to concentrate on processing standardized products as efficiently as possible," says ISDA's Pickel. Then, he says, dealers can "focus on structuring newer, more innovative products at the top of the pipeline, where there are higher margins." There will always be new, less-efficient frontiers for Wall Street to exploit.

Trading derivatives online
Most online systems trading in over-the-counter interest rate and credit derivatives target the interdealer market.
Platform Instruments offered Users When started
Blackbird Interest rate swaps Interdealer, dealer to customer 1999, 2004 (dealer to customer)
Bloomberg Credit and interest rate derivatives Single dealer to customer Various
Bloomberg SwapTrader Euro interest rate swaps Multidealer to customer 2005
Creditex Credit derivatives Interdealer 2000
CreditMatch (GFI Group) Credit derivatives Interdealer 2004
EuroMTS Interest rate swaps Interdealer Second quarter 2006
ICAP (BrokerTec) Credit default swaps Interdealer 2004
ICAP (ISwap) Interest rate swaps, index swaps Interdealer 2003–'04
MarketAxess Credit default swap indexes Dealer to customer To launch late 2005
Reuters Matching for Interest Rates Euro interest rate swaps Interdealer 2004
Thomson TradeWeb Eonia and Euribor swaps Dealer to customer 2005

Credit default swap indexes Dealer to customer To launch late 2005

Source: Celent; Institutional Investor research.

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