www.

iflexsolutions
.com

Swaps: has the time (finally) come

for electronic trading?
 www.
iflexsolutions
.com
BY HARRELL SMITH
The success of electronic trading in both the
equity and fixed income markets prompted
many observers to conclude that interest
rate swaps would follow suit and migrate
to electronic trading platforms. The swaps
market, many argued, was ripe for an overhaul.
After all, trading, confirmation and processing
remain highly manual processes, while brokers
continue to reap some of their largest fees
from interest rate swaps. Although swaps, like
other OTC derivatives, are highly customized
financial instruments, many in the industry
felt that at least part of the swaps market was
sufficiently standardized to be traded online.
In response, several platforms were rolled
out that promised to make the swap market
significantly more efficient. Initial results
were not encouraging. The majority of these
initiatives failed to attract significant interest
from the market and folded soon thereafter.
The past 18 months have seen a resurgence
in electronic swap trading, however, and a
number of players have moved forward very
aggressively to stake their ground in this
emerging market.
Interest Rate Swaps Defined
Broadly defined, interest rate swaps are
transactions in which two parties agree
to make periodic payments to one another
for a specific length of time on the basis of
specific interest rates on an agreed-upon
notional amount. Interest rate swap market
participants use swaps to transform one type
interest rate swaps are transactions in which two parties agree
to make periodic payments to one another for a specific length
of time on the basis of specific interest rates on an agreed-upon
notional amount.
of interest liability into another (for example, a
floating rate liability into a fixed rate liability,
or vice versa).
Swaps vary widely with respect to underlying
asset, maturity, style, and contingency
provisions. Negotiated terms include starting
and ending dates, settlement frequency, the
notional amount on which swap payments
are based, and published reference rates on
which swap payments are determined. In
general, swaps are broadly grouped into one of
two classes—vanilla interest rate swaps and
exotics.
• Vanilla swaps. Vanilla (or “plain vanilla”)
swaps are by far the most common type of
interest rate swaps. Although definitions
vary from firm to firm, vanilla swaps
generally refer to single-currency, fixed-
float contracts. Payments made by one
counterparty are based on a floating rate
of interest (such as the London Interbank
Overnight Rate, or LIBOR), while payments
made by the other counterparty are based on
a fixed rate of interest (normally expressed
as a spread over an underlying interest
rate security, such as a US Treasury).
Floating leg payments are generally made
according to the reset, or fixing, schedules
of the underlying rate (e.g., quarterly for
three-month LIBOR, semi-annually for six-
month LIBOR), while fixed rate payments
are generally made on a semi-annual
basis. By convention, the fixed rate payer
is designated as the swap buyer, while the
floating rate payer is the seller.
• Overnight Index Swaps. Overnight
Index Swaps (OIS) are fairly standardized
products, but differ from vanilla swaps in
two important ways. First, maturities for
OIS generally do not exceed one year and
can be as short as a month, a week, or
even a few days. Second, fixings are tied to
daily, published averages of overnight inter-
bank rates. Interest is compounded daily
and settled at maturity. EUR-denominated
overnight index swaps are known as EONIAs
(European Overnight Index Averages)
• Exotic swaps. As their name implies,
exotic swaps are much less standardized
than vanilla swaps. The past decade
has seen an increase in the variety and
complexity of exotics, reflecting the
growing sophistication of global capital
markets. Examples of exotic swaps include
callable time swaps, callable ratchet inverse
floaters, and target note swaps. Exotic
swaps are tailored specifically to the needs
of individual clients, and as such are traded
heavily within the dealer-to-client market.
The global interest rate swaps market has
experienced significant growth in recent
years. According to figures compiled by
the International Swaps and Derivatives
Association (ISDA) and the Bank for
International Settlements (BIS), total notional
outstanding has increased from US$36 trillion
in 1998 to a staggering US$127 trillion in
June 2004. Over the same time period, average
daily trade volumes for swaps increased from
US$155 billion to US$611 billion. In fact,
interest rate swaps are the most widely held
single product type among all OTC derivatives,
accounting for 56 percent of total notional
outstanding worldwide.
In general, the swaps market is characterized
by low trade volumes (~3,500 per day
worldwide), counterparty-specific pricing (due
to differences in firm credit ratings) and a
lack of automation in both trading and deal
processing.
The Move to Electronic Trading Platforms:
Strategic Issues
By any standard, early attempts to automate
swap trading produced dismal results.
Regardless of past failures, the perceived
benefits of electronic trading—reduced
transaction costs and increased operational
efficiency—remain the rallying cry of
the electronic swap brokerage industry.
Specifically, proponents of electronic trading
platforms claim electronic swap trading
offers three advantages over traditional swap
markets:
• Increased market transparency.
Multi-dealer platforms can function as
anonymous liquidity aggregators, providing
a deeper view of the market while tightening
spreads.
• Significantly reduced transaction
costs. Technology and reduced overhead
allows these firms to offer significantly
reduced brokerage fees. While none of the
firms with whom Celent has spoken would
disclose exact fee schedules, all maintained
that they offered deep discounts (as much
as 50 percent) against prices charged by
traditional voice brokers.
• Increased operational efficiency via
straight-through processing (STP).
Firms will see an overall reduction in
operational overhead and error rates
through increased STP integration. STP
also will allow firms to reduce Basel II-
mandated capital reserve requirements,
making swap trading significantly less
capital-intensive.
While the potential benefits of automated
swap trading are clear, market entrants face
numerous obstacles in their attempts to gain
wider acceptance among major swap dealers
and client firms alike.
• Industry skepticism. On the whole,
traders remain skeptical about electronic
swap trading platforms. Many firms view
these systems as cumbersome imitations
of traditional voice-brokered markets
that provide few, if any, advantages over
traditional execution methods. In addition
to complaining about basic screen space
issues and the inevitable learning curve
associated with new systems, many traders
believe that rigid electronic platforms are
not particularly well adapted to the trading
of complex and highly differentiated
financial instruments.
• Lack of standardization. The variety and
complexity of swap instruments remains
a major stumbling block for electronic
brokerage firms. Initial product rollouts
have focused on the short end of the
curve, supporting relatively standardized
EONIAs and USD OIS, as well as short-
dated vanilla interest rate swaps. Although
many platforms provide APIs with which
traders can automatically upload quotes
and refresh prices in real time, most
traders find it easier to verbally negotiate
the particulars of a swap transaction.
• Pricing. While market transparency is
touted as a primary benefit of electronic
swap trading platforms, fully transparent
platforms are incompatible with the
traditional pricing methods used by inter-
dealer brokers and banks. Brokers are
reluctant to show their best prices to every
dealer in the market, while dealers adjust
their spreads based on trading relationships
and counterparty credit. Firms have
addressed this issue in different ways.
Some platforms allow for counterparty
exclusion, in which firms may show their
prices to selected counterparties only.
Others incorporate more advanced tiered
pricing engines, which allow firms to
show different quotes to various groups of
clients according to credit levels and dealer
preference.
Regardless of which technology a platform uses, credit remains
an issue that has hampered the introduction of fully anonymous
electronic execution.
• Credit management. The need to monitor
credit in real time presents a significant
challenge to designers of anonymous quote
matching platforms. Swaps, particularly
longer-dated interest rate swaps, expose
counterparties to significant credit risk.
Before firms transact with one another,
credit agreements must be signed that
specify, among other details, what type of
swaps may be traded and for what notional
size. Lines of credit are established as
well, limiting firms’ overall exposure to one
another. Traders check in-house systems to
ensure sufficient credit lines exist before
executing a trade.
Name-based credit checks of this type are
inconsistent with automated swap trading
systems, all of which employ anonymous
order matching technology. To address this
problem, many electronic swap platforms
use dynamic credit checking systems that
monitor and adjust counterparties’ credit
lines in real time, warning users when
lines are nearing saturation. These “pre-
clearance” engines color-code prices to
indicate whether a quote is available for
trading and prevent participants from
dealing when the potential trade exceeds
credit limits. In most cases, systems that
use dynamic pre-clearance functionality
let all participants view all posted
quotes, regardless of credit status. Other
systems use simple counterparty exclusion
technology, which allows participants to
limit display of quotes to certain parties or
groups of parties based on credit or dealer
preference. Regardless of which technology
a platform uses, credit remains an issue
that has hampered the introduction of fully
anonymous electronic execution.
Adoption of Electronic Trading and Leading
Market Participants
To date, trade volumes for electronic swap
platforms remain extremely limited. Celent
estimates that as of 2004, about 21/2
percent of all interest rate swaps were traded
electronically, with EONIAs accounting for
almost all activity by traded volume. Between
10 and 12 percent of the EONIA market is
now traded electronically, and Celent estimates
that this figure will reach 35 percent by the end
of 2006. Growth for longer-dated maturities
will be much less pronounced. Celent predicts
that less than 5 percent of all medium- and
long-term interest rate swaps will trade
electronically by the end of 2006.
In the inter-dealer market, leading trading
platforms include I-Swap, owned by inter-
dealer broker ICAP, as well as independents
ATFox and e-Mider. I-Swap has emerged as
the clear leader in this category, while early
market entrants ATFox and e-Mider struggle
for liquidity. In the so called multi-dealer-to-
client market, where dealer banks either (1)
populate platforms with competing bids against
which clients may deal either directly, or (2)
interact via an RFQ model, competitors include
Thompson TradeWeb, Bloomberg, Reuters’
Matching for Interest Rates and Swapstream.
Among single dealer platform, Barclays’ BARX
platform on Bloomberg remains the industry
leader, although other dealers such as Morgan
Stanley have since entered the fray.
The Future: Not “If” But When
Electronic swap trading will continue to gain
market share in terms of overall trade volumes,
with short-dated maturities leading the way.
Short-dated swaps, particularly EONIAs and
USD OIS, are relatively liquid, undifferentiated
products. Customer credit plays a much smaller
role in this sector, particularly among inter-
dealer banks. EONIAs currently represent
the largest single segment of the interest rate
swaps market, and along with USD OIS will
continue to see significant growth in electronic
trading volumes for the foreseeable future. In
contrast, the overall market for long-dated swap
trading is characterized by highly differentiated
products, varying credit levels, and customer-
specific pricing. These issues are less prevalent
in the inter-dealer vanilla IRS market, and
Celent expects that trading in this segment will
eventually migrate to a predominantly electronic
medium. Still, this transition is unlikely until
electronic swap brokerage platforms have
demonstrated their value in the more liquid and
undifferentiated short-dated markets. In the
meantime, inter-dealer platforms will continue
to struggle for longer-dated liquidity. As noted
above, Celent predicts that electronic volumes at
the long end of the curve will remain extremely
limited for the next two years.
In addition, market adoption will be much
more pronounced in Europe than in the United
States. In the US, liquidity in concentrated
among a few large dealers, while in Europe, the
market is characterized by more fragmented
pools of liquidity. As a result US dealers are
understandably more reluctant to put their
prices up on electronic trading platforms, where
spreads will inevitably tighten. EONIA’s have
also achieved near-benchmark status in Europe,
making them the single most actively traded
swap instrument in the world.
The electronic swap trading market continues to
develop, albeit haltingly. Although the potential
benefits of electronic trading remain clear, the
industry faces considerable obstacles in its
attempt to gain wider acceptance among major
swap dealers and client firms alike. Liquidity is
still the overriding objective for electronic swap
brokerage firms, whose success is currently
measured in single-digit daily trade volumes.
The failure of Blackbird, one of the most
technologically advanced systems on the market,
remains the industry’s cautionary tale about
pursuing a build-it-and-they-will-come strategy.
New market entrants are confident that their
combination of liquidity and market-making
agreements, hosted distribution strategies, and
integrated platform models can jump-start the
industry and convince the market that the time
has finally come for electronic swap trading.
Celent Communications is a consulting and
advisory firm dedicated to helping financial
institutions, in particular in the area of
information technology and its application.
Celent assists firms in defining both new business,
as well as new technology strategies.

Our consultants have advised many of the

largest financial institutions in the world, as well
as leading technology vendors.

i-flex solutions limited, i-flex Park, C/o Embassy Business Park, C.V Raman Nagar, Bangalore-560093, India

Contact our marketing offices

New York New Jersey Minneapolis Boston Miami
Tel: +1-646-619 5300 Tel: +1-646-619 5320 Tel: +1-952-942 6297 Tel: +1-617-854 7451 Tel: +1-646-619 5401
Fax: +1-212-430 1918 Fax: +1-732-548 6030 Fax: +1-952-942 6451 Fax: +1-617-549 9304 Fax: +1-786-275 8681

London Amsterdam Frankfurt Dubai Shanghai

Tel: +44-207-531 4400 Tel: +31-20-575 4200 Tel: +49-69-3085 5901 Tel: +971-4-391 1890 Tel: +86-21-6375 8562
Fax: +44-207-531 4401 Fax: +31-20-575 4201 Fax: +49-69-3085 5104 Fax: +971-4-390 4876 Fax: +86-21-6375 9456

Singapore Tokyo Mumbai Bangalore

Tel: +65-6238 1900 Tel: +81-3-5521 1166 Tel: +91-22-2839 1909 Tel: +91-80-5759 7000
Fax: +65-6238 1282 Fax: +81-3-5521 1167 Fax: +91-22-2836 3140 Fax: +91-80-2534 5090

Connect with us at www.iflexsolutions.com e-mail: marketing@iflexsolutions.com June, 2005

COPYRIGHT (C) 2005 i-flex solutions
All rights reserved. No part of this work may be reproduced, stored in a retrieval system, adopted or transmitted in any form or by any means (electronic, mechanical, photographic, graphic, optic recording or otherwise), translated in
any language or computer language, without the prior written permission of i-flex solutions.
Due care has been taken to make this document as accurate as possible. However, i-flex solutions makes no representation or warranties with respect to the contents hereof and shall not be responsible for any loss or damage caused
to the user by the direct or indirect use of this document. Furthermore, i-flex solutions reserves the right to alter, modify or otherwise change in any manner the content hereof, without obligation of i-flex solutions to notify any person
of such revision or changes.
This announcement contains forward-looking statements regarding platforms to be supported. General availability, prices, final functions, ordering information, and terms and conditions will be provided when the actual products are
announced.
i-flex and FLEXCUBE are registered trademarks of i-flex solutions. Reveleus, Daybreak, PrimeSourcing and Equinox are trademarks of i-flex solutions and are registered in several countries.
All company and product names are trademarks of the respective companies with which they are associated.