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Single-Dealer Platforms in a Cleared World BY PAUL CAPLIN

April 2012

Far from signaling the end of singledealer platforms, the impending raft of new regulation in the US and Europe will create a new business environment in which the direct online channel is more important than ever for both banks and their clients.

Paul Caplin, CEO of Caplin Systems Ltd. founded the company in 2000

Soon after the publication of the Dodd Frank act in the US, some early commentators suggested that the forthcoming prohibition of bilateral trading of liquid swaps signaled the death knell of single-dealer platforms (SDPs), the banks proprietary online trading offerings. But, as with Mark Twain, reports of their death were greatly exaggerated. Far from backing away from SDPs, virtually all tierone banks and many smaller firms have responded to the imminent shift in market structure by increasing their spending on SDPs.

According to FX Week, the head of foreign exchange at a top-tier bank recently described this as the secret weapons program now under development at most banks. The successful SDP of tomorrow will provide essential customer services in a fragmented multilateral marketplace. It will deliver swap execution facility (SEF) and organized trading facility (OTF) aggregation and smart order routing, integrate this smoothly with OTC trading of illiquid/off-the-run instruments, and link it to the clearing and collateral management

services through banks will actually make most of their money as parts of their business switch from a principal to an agency based model. Banks that understand and embrace this will establish a secure and profitable position at the centre of their clients trading workflow. This paper explains how this will work, and looks at what banks stand to gain from proprietary online channels in the new world order.


Rules and regulations

A major consequence of the 2008 financial crisis was a new and aggressive approach to the regulation of the over-the-counter (OTC) financial markets. Agreed in principle at the G20 summit in 2009, and reaffirmed the following year, this regulation is being introduced via the Dodd-Frank act in the US and under the umbrella of the EMIR/MiFID II/ MiFIR programs in the EU. The stated goal of regulators in both cases has been to reduce systemic and counterparty risk by banning OTC trading of a broad range of liquid instruments, mandating instead a central counterparty (CCP) model for clearing and obligatory use of multilateral trading venues. At the time of writing, we are still months from knowing the final form that the new regulations will take, and there is a clear (and potentially worrying) divergence between the approaches being taken in the US and EU. The regulations in the US are primarily focussed on the swaps markets, and will not affect bonds. Foreign exchange (FX) spot and swaps trading have also been excluded. In Europe, however, a much broader scope is envisaged for the MiFIR juggernaut, whose scope currently includes almost all OTC foreign exchange and fixed income instruments. In the US, the CFTC has made it clear that banks will not be permitted to own or control SEFs, the venues on which centrally cleared swaps will trade. A recent Tabb Forum post1 entitled Can Single Dealer Platforms Become Organized Trading Facilities? points out that the EU regulations are still unclear on whether banks will be permitted to own OTFs in Europe, but that probably they will not. The result is that a wide range of liquid swaps (in standard size and term) and potentially other instruments in Europe will soon be traded in the West only through multilateral execution venues and cleared through CCPs. Banks will no longer be permitted to deal directly with their clients in those instruments.

We reaffirm our commitment to trade all standardized OTC derivatives contracts on exchanges or electronic trading platforms, where appropriate, and clear through central counterparties (CCPs) by end-2012 at the latest
From the communiqu of the G20 summit, Toronto, June 2010

April 2012

Liquidity fragmentation
At the time of writing, around 40 firms are planning to register as SEFs in the US, and/ or OTFs in the EU. Some of these will fail, of course, but there seems to be a general expectation that at least 3-4 will survive and compete in each asset class in each region, and this number may grow over time. Recent research from Rule Financial shows that buy-side users are already expecting liquidity to fragment across multiple venues under the new regime (see Figure 1 and Figure 2). David Holcombe of Rule Financial comments that these show an expectation to use the platform thats already on your desktop to address day one regulatory burden, and that this initial concentration of liquidity in major venues such as Bloomberg is likely to be dissipated as the market fragments with new entrants into the SEF space perhaps particularly those with a business case enhanced by SEF aggregation taking market share from the incumbent MDPs.

Fig. 1 Buy-side predicted future execution venues for IRS Source: Rule Financial2


Fig. 2 Buy-side predicted future execution venues for CDS Indices Source: Rule Financial3

Figure 3 (overleaf) shows some of the new entrants to the SEF space in the US. This community is clearly still growing. But it is still more complicated than this, because many swaps will be too illiquid or specialised to be centrally cleared, and so will continue to trade through OTC dealers. As a result, market participants will in general need to continue to trade OTC as well as via SEFs and OTFs.

At the same time, new challenges in understanding and managing risk in the aftermath of the credit crisis has greatly accelerated the pace of migration to electronic trading of OTC products, even without new regulation. For example, less than three years ago hardly any credit default swaps (CDSs) traded electronically. Now, more than 90% of the trading in some Index CDSs is electronic.

April 2012

Fig. 3 SEF snapshot, April 2012 Source: The OTC Space4

Liquidity aggregation
We have been here before: this combination of a transition to electronic trading plus market regulation is what caused the equities marketplace to expand from a handful of national stock exchanges in the late 1990s to a huge range of ECNs today. The US equities market alone now has over 50 execution venues, and 37% of all US equity trading is now executed away from exchanges. In response to this, the buy side sends nearly 40% of its order flow through algorithms designed to aggregate the liquidity and manage it efficiently. The same kind of outcome is widely expected in the OTC market. As liquidity becomes fragmented, users will need to aggregate and manage it across multiple venues to achieve best execution. Banks that want to retain their customers will need to provide this service. This is not a controversial view: TABB Group reports that 87% of swaps dealers are already either building or about to build SEF aggregation technology , and that over 70% of respondents in each asset class thought that SEF aggregation would become common once the new rules were in place (see Figure 4). Banks such as Deutsche, RBS and UBS have already announced their plans to offer this kind of service7


Fig. 4 Percentage, by asset class, who believe SEF aggregation will become common Source: TABB Group6

Follow the money

Investment banks are in the business of providing clients with access to the capital markets. How they profit from doing this varies widely from market to market. In the OTC markets, they have traditionally made money on the bid/ask spread as dealers, and also particularly in the case of flow monsters from proprietary trading and internalisation of client flows, backed by visibility of client order flow. This is about to change, for the reasons outlined above. Banks will no longer be able to act as dealers in the case of many instruments, and this and other provisions such as the Volcker rule will limit their scope for proprietary trading. The commercial opportunities in these markets over the next few years will instead be mainly about providing added-value services such as SEF/OTF aggregation, clearing, financing and collateral management. In a recent survey8, 78% of a sample of large sell-side firms said that advanced client services of this kind were going to be their primary competitive weapons. In order to do this, they need more than ever to insert themselves into their clients trading workflow, and above all to have a direct electronic route to their desktops. In particular, bank SEF aggregation without an SDP makes very little sense. A recent article in FX Week9 quotes the head of foreign exchange at a top-tier bank describing the secret weapons program now underway at most banks to equip their single-dealer platform offerings for the new reality. When TABB Group survey last year asked the question what will happen to single-dealer portals post Dodd Frank? 41% of respondents replied that they would become SEF aggregators (see Figure 5 overleaf). 18% thought they would become SEFs, or take on a SEF-related role. 26% suggested they would be shut down, which was the early reflex reaction following Dodd Frank but, for the reasons examined in this paper, no longer reflects the views or aspirations of most large banks.

April 2012

Fig. 5 What will happen to single-dealer platforms post Dodd Frank? Source: TABB Group10

The sdps of today

SDPs are currently in a pretty healthy state. Figures are not available for all markets, but in the FX space Bank of England figures show that they attract around half of all dealer-client electronic flow. Figure 6 shows the situation in the FX Swaps market. EuromoneyFXNews recently conducted a survey of buy-side customers representing more than $7 trillion in annual turnover. They reported that voice trading volumes are expected to decline to less than 15% of total volume in the next few years, and that single-dealer platforms (SDPs) will be the main beneficiaries of this migration. The rate of growth on single-bank trading portals is expected to outstrip multi-dealer portals by almost seven to one. However, with a few honorable exceptions, the majority of SDPs available today remain exclusively focused on trade execution, with at best modest links to pre-trade data and post-trade processing. And the pace of adoption in the fixed income markets has not matched that in FX. Both these things are going to change.


Fig. 6 Total FX swaps volumes through single-dealer platforms vs. multi-dealer platforms Source: Caplin/Bank of England data

The future is bright

The successful SDP of tomorrow will offer SEF/OTF aggregation, integrate this smoothly with OTC trading of illiquid/offthe-run instruments, and provide the clearing and collateral management services through which banks will actually make most of their money. Good SDPs will provide smart order routing (SOR) to SEFs and OTFs. Over time, they will add increasingly sophisticated algorithmic functionality for execution management. Above all, they will harness all that forward-thinking banks have learned about user experience (UX) design in recent years to fully support client workflow and meet users needs throughout the trading lifecycle. Today, a well designed SDP provides a far superior user experience to any MDP, simply because it doesnt need to be a lowest common denominator solution: its operator is free to add as many advanced features as it wishes without having to worry about upstream dealers supporting them. But the main objection to SDPs remains that they dont automatically ensure best execution compliance (although some are starting to address this), which makes them problematic for some classes of users. In the SDP of the future, however, the bank becomes primarily an agency broker rather than a dealer, providing added-value access to a multilateral marketplace. This goes a long way to solving the best execution problem, and potentially positions an SDP as the best choice of all when accessing these markets. The result is a win/win situation in which the client is provided with high-quality, integrated tools to support him throughout the trade lifecycle, while banks that offer these tools win a secure place on client desktops and the opportunity to sell a range of profitable services.

April 2012

What about smaller banks?

As noted above, almost all global tier-one banks and some of the larger tier-twos are currently developing a SEF aggregation/ enhanced SDP strategy. But what about smaller banks? Can they achieve something similar, will they continue with business as usual, or will they be marginalized? In recent years, most of these firms have followed in the footsteps of their larger cousins by creating their own liquidity aggregation and electronic trading systems for the OTC markets, and developing their own SDPs. Much of this activity will simply carry on, serving, as before, a captive local market with specialized requirements for which global flow products are of limited interest. Before long, however, it is likely that the more ambitious and forward-looking of them will start to develop SEF aggregation services of their own, just as they have developed liquidity aggregation services over the last few years. In this they will undoubtedly be assisted by vendors offering a SEF/ OTF aggregator in a box. But most of them are unlikely to take this next step until the SEF/MTF landscape has settled down and the winners and losers are clear. Above all, the renewed focus on SDPs among tier-one banks, and their likely key role in a centrally-cleared world, mean that smaller banks are likely to continue investing in SDPs in the confidence that they will be more, not less, valuable in the future.

Faced with a revolution in OTC trading in the US and EU, banks need to bring their clients with them as they adapt to the new order. They can do this by helping those clients cope with challenges such as liquidity fragmentation and collateral management. An effective single-dealer platform is key to achieving these goals. That is why, far from retreating from SDPs in the face of new regulations and market changes, leading banks are now investing in them more heavily than ever.



References 1. TABB Forum, 29 September 2011: Can Single Dealer Platforms Become Organized Trading Facilities? 2. Rule Financial, 12 March 2012: Dodd Frank 18 months on, is the landscape any clearer? 2012 Rule Financial OTC clearing and collateral management survey results http://www. aspx 3. Rule Financial, 12 March 2012: Dodd Frank 18 months on, is the landscape any clearer? 2012 Rule Financial OTC clearing and collateral management survey results http://www. aspx 4. The OTC Space, 2 April 2012: State of the ecosystem snapshot state-of-the-ecosystem-snapshot 5. TABB Group, October 2011: Credit and Rates Swap Dealers 2011: Redefined and Reborn aspx?PublicationID=996 6. TABB Group, April 2011: Swaps Liquidity Aggregation: Best Execution to Product Selection aspx?PublicationID=1032 7. See for example: http://singledealerplatforms. org/2011/10/15/ubs-to-enable-clients-to-routeswaps-orders-to-sefs 8. Rule Financial, 2012: OTC clearing and collateral management report launch-of-2012-otc-clearing-and-collateralmanagement-report.aspx 9. FX Week, 19 Dec 2011: The Secret Weapons of E-Commerce http://www. secret-weapons-commerce 10. TABB Group, 1 December 2011: SEF Industry Barometer: Fall 2011 http://www. researches/sef-industry-barometer-fall-2011 11. EuromoneyFXNews e-trading survey Category/16/ChannelPage/3301/ EuromoneyFXNews-e-trading-survey-Actionstations-for.html

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