Changing Market Structure is Hard
The trueEX Lawsuit and Interest Rate Swaps Market Structure
Earlier this month, trueEX, an independent exchange for interest rate swaps (“IRS”), filed a lawsuit against eleven banks, including all the major swaps dealers, for “an ongoing conspiracy … to boycott trueEX in order to undermine increased competition in the IRS market… .” trueEx’s lawsuit is similar to cases brought by two other IRS exchanges: Javelin Capital Markets and TerraExchange. All three cases are represented by the same law firm and are piggy-backing off a larger IRS class action suit.
At 124 pages, the suit is a fun read. It is filled with first-hand accounts of interactions with recognizable names from the dealer community:
… when trueEX confronted Goldman Sachs to complain about [dissuading customers from using trueEX] in 2014, Rana Yared’s excuse was that Goldman does not suggest that clients join any platform in particular, but “only make them aware of where at any point in time they can access our liquidity.” This excuse was repeated by her colleague Bryan Koplin, who claimed that Goldman Sachs was only interested in learning more about the trueEX customer’s interest and “educating” those customers on their liquidity options.
For the lawsuit to succeed, trueEX will need to prove more than that the dealers did not want to participate on trueEX or even that dealers tried to get their customers to use another platform. (Caveat: I am not a lawyer and you should definitely not take legal advice from a newsletter.) If dealers acted in their own self-interest, then most of the actions described in the lawsuit are likely completely legal. However, if the dealers coordinated actions with each other, trueEX might have a case. In my reading of the lawsuit, there is no “smoking gun” to prove collusion. However, there does not need to be one at this point. If the lawsuit passes a motion to dismiss by the defendants, then trueEX can engage in discovery of the defendants’ emails and Bloomberg chats, which might reveal something more interesting.
Instead of speculating on the likelihood of trueEx prevailing, I want to use some of the major accusations as a starting point to explore IRS market structure. In my research for this article I spoke with 11 sources familiar with trueEx and the IRS market. The CEO of trueEX, Sunil Hirani, originally agreed to be interviewed for this article, but his public relations firm spiked the meeting. Most sources asked to speak on background because they are not authorized to speak on behalf of their firm.
Bespoke Agreements
An IRS is a trade of interest rate cash flows for a specific term and notional value between two counterparties. In the most common type of swap, one counterparty pays the other a fixed interest rate in exchange for receiving a floating interest rate. The floating rate is often tied to an industry benchmark, such as LIBOR.
Historically, swaps were only traded by large institutions such as GSEs and insurance companies who needed to hedge either fixed or floating interest rate exposure. Trades were infrequent, large, and often involved the lengthy negotiations of contracts. Banks, who had their own interest rate exposures, were the only providers of liquidity, earning a rent from buy-side customers for the use of their balance sheet.
As we have discussed previously in Trading Places with regard to Treasury and equity trading, dealers determine the market structure absent regulation. As such, the swaps market developed with bi-lateral trading over the phone. As swaps became more standardized, electronic request-for-quotes (“RFQ”) automated the telephone call, but the basic structure of the relationship between dealer and customer has not changed. Customers still disclose their identity, size and direction on every transaction.
Order Books
As part of the CFTC’s Dodd-Frank rules, all Swap Execution Facilities (“SEFs”) are required to offer an electronic order book. However, SEFs could still offer traditional RFQ trading. trueEX, like many of the new upstart SEFs that appeared after Dodd-Frank, first focused on building an all-to-all central limit order book (“CLOB”). The lawsuit claims that these efforts were thwarted by a dealer boycott:
The Dealer Defendants prevented the emergence of all-to-all trading principally by boycotting market entrants like trueEX that dared to try to open up electronic all-to-all IRS trading platforms to the buy-side. … These efforts have “been relentless — sometimes buried in SEF rulebooks and trading workflow minutia, and other times amounting to outright intimidation.” The Dealer Defendants needed to act together to ensure that neither trueEX nor the other nascent SEFs gathered enough liquidity from the Dealer Defendants or alternative liquidity providers to pose a threat to the Dealer Defendants’ privileged position in the marketplace.
It is not controversial to say that banks had no interest in participating in a CLOB to make markets to clients. Banks could already trade with customers through RFQs on a fully-disclosed basis. As one bank employee admitted to me, “connecting to trueEX’s CLOB never even came up at a meeting.”
By mandating order books, the CFTC was trying to emulate the efficiencies of the equities (and futures) market. However, there are some significant differences. Swaps have a relatively small number of participants, while equities have thousands. IRS trades are infrequent and chunky, while equities trades are frequent and tiny.
Most importantly, there is little competition to the banks as liquidity providers. Hehmeyer Trading, a Chicago trading firm, stopped its initiative. Getco/KCG looked at the trading of swaps for over five years, but it never executed a single trade. John Shay similarly explored trading swaps but could never find a place for Virtu in the market. Only Citadel has made a dent in market share, and it looks more and more like a bank every day. CLOBs can provide better pricing than RFQs, but CLOBs require a level of competition for liquidity provision that does not currently exist in the swaps market.
Request-for-Quote
trueEX also offers an RFQ platform, which allows dealers to make markets to buy-side customers and trade on a fully disclosed basis. According to the lawsuit, dealers demanded that trueEX produce proof that there was client interest if they were to participate.
Frequently, the Dealer Defendants insisted that trueEX instruct their buy-side customers to contact Dealer Defendants directly, ostensibly to test customer demand, but in reality so that they would have a chance to steer the customers’ business away from trueEX. …
Once the customers actually contacted the Dealer Defendants, the Dealer Defendants attempted to force the customer to justify its interest in trueEX, to dissuade the customer from using trueEX, or to explicitly pressure the customer to use Tradeweb instead.
You can understand the frustration of trueEX. trueEX’s employees have long-standing relationships with a number of buy-side customers. trueEX got those customers to go out on a limb and ask the bank about trueEX. And then the bank tells the customer that there is no need for trueEX and to use Tradeweb instead. It is not hard to imagine the following exchange:
Buy-side: “We like this trueEX platform. Can you support it?”
Dealer: “We are not on trueEX right now, but you can find us on Tradeweb.”
Buy-side: “But I really like the trueEX GUI.”
Dealer: “We will take that into consideration at our next meeting about new platforms. Hey, look at that, the 5Y just popped. The last time it was at this level you were looking to hedge your duration. Want to hedge with an IRS?”
Buy-side: “OK.”
This push/pull happened at every dealer. The lawsuit describes an incident with Rob Grillo, Head of Rates Sales at Bank of America, as downplaying customer interest in the platform.
a trueEX sales representative asked Rob Grillo [] if trueEX could provide a demonstration of trueEX’s IRS platform in August 2015, noting “[b]uy side clients on the platform would like to have the ability to execute both risk and non-risk packages with BAML via trueEX.” Mr. Grillo responded that Bank of America “had no client contact re: TrueEX — round risk trades.” After the trueEX sales representative listed four buy-side customers … that had specifically expressed interest in trading with Bank of America on trueEX, Grillo retreated to the excuse that Bank of America had “limited resources” to explore joining trueEX.
Mr. Grillo, recalls the incident very differently. Mr. Hirani gave Mr. Grillo and others a demo at the trueEX offices. Mr. Grillo agreed that he would discuss the platform with his clients and if there was demand he would bring it to his boss, the co-head of sales. “On my walk back to the desk, Sunil sent emails to ten customers, cc’ing me.” The emails described a “partnership” between Bank of America and trueEx. “I immediately asked for a retraction and an apology because that is not what we agreed to.” Mr. Grillo then emailed each customer to correct the record. “I never heard from him again.” Mr. Grillo said he still followed up with customers and did not find demand for “risk trades” on the platform.
You can easily imagine how both sides would see the situation differently through the lens of their own institutions and biases. Incumbency is a tough thing to dislodge. Banks own a stake in Tradeweb. Clients are already connected to Tradeweb and Bloomberg for other asset classes. Getting them to move to another platform with the same liquidity providers is an uphill battle.
Central Clearing
Before the crisis, swaps were an opaque market. The Government was frustrated in its attempts to understand the systemic counterparty risk Lehman, AIG, Fannie Mae, Freddie Mac, and a number of other institutions wounded in the crisis.
One of the objectives of the Dodd-Frank Act was to bring greater transparency to the swaps market. The law required that most swaps be centrally cleared. Central clearing also allows for anonymous trading protocols (e.g., an order book) to develop, as the central clearing counterparty (“CCP”) is the counterparty to all transactions.
Cleared swaps comes with a catch for platforms. A clearing firm must first certify the SEF before its buy-side customers can begin trading. Most clearing firms are part of the same holding company as the IRS trading desk. In the lawsuit, trueEX describes years of manufactured delays and outright instructions by the trading desk to not proceed with clearing for customers on trueEX:
During a SIFMA conference in October 2014, a Deutsche Bank clearing employee, Mark Millindorf, told a trueEX officer that he had been instructed by the trading desk not to onboard trueEX. Millindorf indicated that the instructions from the Deutsche Bank trading desk came from Sagar Gohel, Chuck Fletcher, or Tom Hartnett. The following year, the trueEX officer reached out to Piers Murray at Deutsche Bank’s clearing unit asking for a “fresh look,” noting that he was previously “told that DB execution desk had instructed DB Clearing not to sign up to trueEX” despite being “ready to execute.”
trueEX eventually wore the clearing firms down. Of the 11 dealer defendants, all except Deutsche Bank and RBS provide clearing services for trueEX. Theoretically, a buy-side participant could trade on trueEX’s order book anonymously. However, there is one more catch. Even though order books are anonymous, all dealers require the use of MarkitWire for post-trade processing. After an IRS trade is completed, the platform submits the trade to MarkitWire. MarkitWire then discloses the names of the counterparties to each other before submitting the trade to the clearing house. This effectively removes the anonymity that a CLOB was intended to provide.
MarkitWire is a trade processing service for IRS and other asset classes offered by MarkitSERV, meaning it delivers trades to clearinghouses once they have been executed by counterparties. While it is possible to design IRS trading platforms to feature “straight-through processing” — where a trade is immediately sent to a clearinghouse by a SEF once it is executed — the Dealer Defendants force IDBs to send trades to MarkitWire before they are cleared. MarkitWire then offers the counterparties to an IRS transaction a “last look” at the trade, where they learn each other’s identities and have the option to terminate the transaction.
Buy-side firms are not likely to use an anonymous order book that is not really anonymous. They are too afraid of being put in the penalty box if a dealer were to find out. Dealers defend the need for MarkitWire for the complex trade processing involved in a swap. In my opinion, MarkitWire is a piece of legacy infrastructure from the pre-Dodd-Frank days. The industry would do well to move on. Regulators should intervene if name give-up conflicts with the stated goals of Dodd-Frank.
Market Structure is Hard to Change
There was a lot of hope in the aftermath of Dodd-Frank that the IRS market would become more open and transparent. Independent SEFs such as TerraExchange, Javelin Capital Markets, and trueEX hoped to break into a new market structure that would look a lot more like equities and futures. Whether it is due to collusion, dealer self-interest, lack of interest from buy-side customers, and/or the particulars of swap instruments, one conclusion is clear: The market structure has not changed appreciably. Absent new liquidity providers or additional regulation, it may never change.
