Analysis: Girding for battle as electronic derivatives trading revived

Thu Aug 29, 2013 1:37am EDT
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By Karen Brettell

NEW YORK (Reuters) - The $300 trillion privately traded U.S. derivatives markets could be on the verge of the biggest change in their 30-year history if investors embrace new electronic trading platforms that would reduce the market dominance of large banks.

There is new found optimism among many investors that rules to require swaps to trade electronically will open the markets to new competition, reduce trading costs, and bring price transparency.

Derivatives markets are among the largest in the world, but they remain a market where investors negotiate trades with dealers, instead of allowing investors to trade anonymously with each other. Trading is sometimes infrequent and typically in very large sizes.

Bank exposure to derivatives was a major contributor to the financial crisis that brought down Lehman Brothers and nearly destroyed several other firms. After the financial crisis peaked in 2008, some expected a swift move to exchanges and away from the price opacity of the bank-dominated model.

It didn't happen. Several credit derivatives trading platforms were readied for launch but none succeeded. A European antitrust investigation and a mounting number of lawsuits allege that banks killed a venture planned by Citadel Investment Group and CME Group (CME.O: Quote), and others like it, to protect lucrative revenues they earn from keeping the market private.

Banks have long acted to maintain their intermediary role in fixed income and foreign exchange markets and some are likely to continue to resist trading models that increase competition.

This means that many are likely to favor request-based platforms, known as request-for-quote (RFQ), which are based on bank relationships and replicate how the markets currently work, over order-driven markets that allow investors to bypass them as trade middlemen.

Still, new regulations have also shrunk bank balance sheets and left weaker dealers less able to compete against the largest banks. This means some are likely to support lower-revenue, higher-volume businesses, such as order-book trading, especially if enough investors shift their trades. The new regulatory mandate for electronic trading provides extra impetus.   Continued...

A trader works on the floor of the New York Stock Exchange August 26, 2013. REUTERS/Brendan McDermid