Swaps Pioneers Recall Wild West History as Trading Goes Digital

Now a $426 trillion industry, rate swaps are going through another revolution. On Feb. 15, the Commodity Futures Trading Commission required most to trade on new systems known as swap execution facilities.

(Bloomberg) — Once, the market for interest-rate swaps fit in your pocket.

The year was 1982, when Thomas Jasper, the former Salomon Brothers Inc. banker who helped co-found the International Swaps & Derivatives Association, realized the time was right to open trading to speculators. Swaps up to that point had only been done in concert with bond issuance, locking them away as an investment banking tool. Jasper helped write the contract that standardized the trades, unleashing business and controversy on Wall Street for decades to come.

When I was running the swap desk at Salomon in the early days, I used to carry my trading book in my breast pocket on one piece of paper, he said. Before the creation of the ISDA Master Agreement in 1985, every Wall Street law firm and U.K. law firm got involved with their own contract defining how the contracts should be executed, he said. It was a nightmare.

Now a $426 trillion industry, rate swaps are going through another revolution in the U.S. As of Feb. 15, the Commodity Futures Trading Commission requires most to trade on new systems known as swap execution facilities, with credit contracts to be added later. The rule, one of the most contentious parts of the 2010 Dodd-Frank Act, is the final step in the four-year effort to create a market structure for over-the-counter derivatives after they helped fuel the 2008 financial crisis and then worsened its aftermath.

Shedding Light

Swap execution facilities, or SEFs, are meant to increase transparency and competition in part of the financial world that has been dominated for decades by the largest dealers, such as JPMorgan Chase & Co. and Deutsche Bank AG. Electronic trading on SEFs will mostly supplant the phone calls and instant messages that traders and brokers have used to buy and sell the contracts.

The shift will allow investors to pit several dealers at once against each other to compete for the best price on electronic systems, a change from the practice of calling banks one at a time to ask what they were charging. Another approved method of buying and selling allows swaps users to view prices on a computer screen before they transact with a mouse click.

Interest-rate swap investors agree to make either fixed or floating payments to each other. As rates rise above the agree- upon fixed level, for example, floating payments increase, making money for the holder of the fixed-rate leg of the trade. Pensions and insurance companies use them to protect against investment losses caused by a higher interest rate environment.

Always Inevitable

Its no surprise to Jasper that the market he helped create has finally moved to electronic trading.

While it took longer than he expected to happen, the digital form of the market to me was always inevitable, he said, adding that the delay reflected the money at stake.

A lot of it was the vested interests of the parties that wanted the market to be less transparent, which obviously was the dealers, he said. Peoples bonuses are tied up in that. This has been a very good business for the dealers for a very long time.

JPMorgan, the biggest U.S. derivatives dealer, earned $5 billion in profit from trading fixed-income swaps in 2009 amid the worst year in Wall Street history. Last year, the New York- based bank said the new derivatives rules may cost it $1 billion to $2 billion in revenue. To partially offset that, the fees it can charge customers to help them trade, clear and collateralize swaps may produce revenue of $300 million to $500 million by 2015, the bank said.

$30 Billion

Prior to the regulatory changes brought about under Dodd- Frank, consulting firm Oliver Wyman estimated swaps trading helped produce a combined $30 billion in annual profits at the biggest dealers.

One of the most profitable eras was the early 2000s after credit-default swaps emerged as the newest type of over-the- counter derivative. The contracts suddenly made it much easier to profit on a bond falling in value, and the market for them exploded.

The unregulated trades, which former Fed Chairman Alan Greenspan said in 2006 were often recorded on scraps of paper, ballooned almost 100-fold within seven years to top $62 trillion by the end of 2007, according to estimates from ISDA.

In the early days it was wild, wild west, said Sunil Hirani, an architect of the credit swap market who co-founded brokerage Creditex Group Inc. Ten or 15 years ago the idea of making credit risk fungible and portable was very seductive, he said. The CDS market was growing exponentially and so was Creditex, and thats always exciting.

Taxis, Pizza

Hirani, who started the brokerage with John McEvoy in 1999 with $200,000 in capital, sold it to IntercontinentalExchange Group Inc. nine years later for $513 million.

There was a point in time when we were interviewing taxi drivers and pizza delivery guys to be brokers, Hirani said. It wasnt uncommon for people brought into this world as brokers or traders to go from earning $50,000 a year to making millions.

In credit swaps, the buyer of the contract pays a premium to the seller that provides protection against a company defaulting on its debt. If a default or other event occurs that triggers the agreement, the buyer is paid the value of the CDS contract minus the settlement price of the defaulted bonds.

Beginning Feb. 26, credit-default swap indexes are the next contracts the CFTC will require to trade on a SEF.

Regulators have blamed bets made with credit-default swaps for contributing to more than $2 trillion of losses and writedowns at the worlds largest financial companies during and after the credit crisis. Once mortgages became harder to secure in the mid-2000s, credit swaps were used to replace the debt that was then packaged and sold in synthetic collateralized debt obligations.

Bankers Trust

Swaps were linked to corporate losses and risks to the stability of the financial market long before the 2008 credit crisis. Bankers Trust New York Corp. faced regulatory investigations and lawsuits after a string of swaps sales to its clients ended in losses in the early 1990s. It settled those charges.

Four years later, a consortium of 14 of Wall Streets largest banks rescued Long Term Capital Management LP with a $3.6 billion investment in the fund. LTCM lost about $4 billion when investments including OTC derivatives blew up.

When Lehman Brothers Holdings Inc., one of the largest swaps dealers at the time, declared bankruptcy in September 2008, the lack of market structure for swaps prevented regulators from knowing which banks and financial services companies were at risk of failing next. The U.S. government rescued American International Group Inc. days later after the insurer was unable to meet obligations from its CDS portfolio. Taxpayers ultimately provided $182.3 billion in bailout funds.


Dodd-Frank sought to rectify those lapses by mandating that most swaps be backed with a clearinghouse and traded on SEFs and that all trades are reported to central repositories. The clearing and reporting mandates went into effect last year.

Clearinghouses rely on their bank members to provide billions of dollars worth of cash and assets to hold on reserve in case of a member default. Theyre meant to lessen systemic risk by requiring up-front margin to back every trade and monitor prices throughout the day. When losing positions arise, they demand cash so that risk doesnt build.

The law has created opportunities for companies to capture trading with SEF offerings. In all, 23 of the platforms have received or are awaiting temporary registration from the CFTC. They include ICAP Plc, Tradeweb Markets LLC, Bloomberg News parent Bloomberg LP, TeraExchange LLC and TrueEx LLC.

Automated Trading

Hirani is the founder of TrueEx, though he has shifted his focus to rate swaps from credit.

Its unclear today who the true end-users of credit derivatives are, he said. On the other hand, interest-rate swaps have bona fide end-users, market makers and speculators, which are a necessary prerequisite for a scalable market. He thinks that market could benefit from the increased efficiency that comes with automation.

Compared with trades today that can be done with the click of a mouse, it took weeks to negotiate an interest-rate swap in the early 1980s, according to Jasper. Our real interest was we wanted interest-rate swaps to be tradable, he said. Ultimately that was the driver behind the formation of ISDA. The groups original name was the International Swap Dealers Association, he said.

Clearing swaps and trading them electronically will make the contracts more similar to futures over the next five years, Jasper said. And the regulatory push to ensure a market structure that seeks to reduce systemic risk will continue.

Thats clearly the direction, he said.