Higher Frequency Swaps Trading:
Market Making and Arbitrage
Executive Summary
Whereas before automated swaps trading was both improbable and impractical, OTC derivative reform efforts are setting the stage for some long-overdue market innovation. Automating the trade confirmation process by launching Deriv/SERV in 2004 was a great first step, but that evolutionary change pales in comparison to the changes that are upon us now. Principal trading groups (PTGs) are known as firms that flourish in highly liquid |
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and highly electronic markets. The manual and bilateral nature of the swaps market has kept PTGs on its sidelines for years.
Access to clearing is what opens the door for PTGs and dozens of other firms looking to trade swaps. Just as eBay made it possible and relatively safe to buy goods from an unknown source on the other side of the world, clearinghouses will do the same for swaps. With counterparty risk concerns mitigated, the market can open up to nearly everyone who has the money, expertise and desire to participate. The PTGs we spoke with for this study possess all of those elements.
Market making will come first, providing both RFQ responses and continuous bid/ask spreads for the most liquid interest rate swaps and CDSs. As on-screen liquidity in these markets increases so, too, will opportunities for new arbitrage strategies. Relative value trades are high on the list as PTGs seek to narrow the pricing differentials between cash, futures and swaps products, and make a good profit capturing the spread while doing so.
The end result won’t be known until the end of 2012 at the earliest, but given the realities of the political world we probably won’t see the full implementation of OTC derivatives reform rules wrap up until at least 2013. But the groundwork is set and there is no turning back. The pre-SEF era is upon us, and electronic swaps trading will see slow growth over the coming months regardless of what goes on in regulators’ conference rooms. PTGs will enhance liquidity here as they have elsewhere. The only question is, by how much?
The TABB Group Vision Note Higher Frequency Swaps Trading: Market Making and Arbitrage examines the role PTGs will play in the OTC derivatives market following global regulatory reform. This includes a look at their current place in the swaps market, strategies that will be applied to newly cleared swaps products as well as potential impediments to their success.