Swap exchanges launch in threat to Wall Street profits


By Douwe Miedema

WASHINGTON, Oct 2 (Reuters) - More than a dozen new U.S.exchanges opened their doors for clients on Wednesday, markingthe start of regulated trading of derivatives in a threat to oneof Wall Street's most lucrative businesses.

Business may be tepid at first, because the bulk of the $630trillion market will slowly move over to the exchanges in thecoming months, as part of a gradual implementation of theDodd-Frank law to overhaul Wall Street.

Moreover, the Commodity Futures Trading Commission, whichregulates the so-called swaps - used to offset risk, but mainlyto speculate - has just sent virtually all of its people home aspart of the U.S. government shutdown.

But in the long run, the exchanges are a credible threat toa highly profitable business for banking behemoths such as JPMorgan Chase & Co, Citigroup and Bank of America, who dominate this market.

"Starting next year, it's showtime," said Will Rhode, ananalyst at the TABB Group, a research and advisory firmspecializing in financial markets.

The swaps business generates an estimated $40 billion inannual revenues for the fixed income divisions of Wall Streetbanks, but the new rules drawn up after the 2007-09 financialcrisis put that number at risk.

The new exchanges - called Swap Execution Facilities (SEFs)- allow clients to trade directly with each other, rather thanhaving to go through the banks. That will open up competitionand is expected to lower prices.

"We've been in communication with virtually all of theproviders of these platforms," said Jamie McConnel, who works atChatham Financial, a firm that advises users of swaps aboutregulation and technology.

"We may sign up with multiple SEFs. In the early stages itmay not be who is the best, but a shotgun approach to ensurethat you have that relationship."


The SEFs are run by firms that are already large swapsbrokers, such as ICAP and GFI, but also by newentrants such as Bloomberg LP and Tradeweb, which is largelyowned by Thomson Reuters.

Swaps are financial contracts that enable clients to offsetrisk. One commonly used example is an exchange of fixed interestrate payments for floating payments. Such deals can be highlycustomized and are often of large value.

They are negotiated privately, often over the phone, androse to prominence during the 2007-09 financial crisis, when itturned out they had been used in highly complex financialconstructs into which regulators had no insight.

The new rules put an end to that, even if voice trading willstill be allowed, as long as buyers and sellers can prove theyhave spoken to more than one counterparty.

Swaps will need to be routed through traffic control centers known as clearing houses, which take on the risk that one ofthe market parties fails to pay. This spreads the risk and meansthat firms other than cash-rich banks can now also offer thesetrades.

The change will break open what the TABB Group recentlydescribed as a "gated community" of investment banks who setprices in an opaque process amongst themselves, with clientsunable to shop around for better prices.

The group cites an example it says is typical of a bankcharging $20,000 to execute a trade on a $100 million interestrate swap, a common size. It is a large amount of money for whatcomes at a low cost for the bank.

The new SEFs will likely try to attract clients by offeringlower prices, TABB says, helped by the CFTC's rules that saythat as soon as one SEF offers a product, all others also needto make it available to trade.


The large swaps brokers also need to fight for theirbusiness. They have traditionally mediated swaps deals betweenbanks, while staying away from going after the banks' clients -now the most promising customer segment.

The largest fund managers, who are also heavy users ofswaps, have sometimes taken a more cautious approach to thechanges because they are used to trading swaps in very largesizes, which may become harder under the new rules.

They have often been treated well by the largest banks, twoderivative brokers said, getting good prices and enjoyinglong-standing relations with their banks that enabled them toexecute highly customized deals confidentially.

More clarity about where swaps prices are headed willtranspire in the coming months, when more instruments will starttrading on the platforms and customers gradually decide who theywant to do business with.

Still, the cumbersome process of bringing swaps back intothe oversight fold - after they were exempted at the height ofthe deregulation wave in the 1990s - was too slow, some said,weighed down by persistent bank lobbying.

"The whole industry has a stake in preserving opaque markets... That's their raison d'etre, that's their modus operandi,that's who they are," said John Parsons, an academic at theMassachusetts Institute of Technology.

"That's where their money comes form. They don't want atransparent system. They could create it instantly."

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