Swaps: The Next Frontier

Space may be the final frontier, but swaps will be the next frontier for quantitative and automated trading strategies.

With swap execution facility (SEF) rules completed, swaps in the interest rate swap and credit default swap markets are poised to begin trading electronically, while quants are salivating over potential trading opportunities that will emerge during market adaptation to the new paradigm. Firms have been patiently waiting and positioning themselves to capitalize on arbitrage, relative value and liquidity-related trading opportunities as the swap markets transition to fully regulated execution and mandatory clearing. Almost three years into the Dodd-Frank Act, the wait is almost over, and trading is going to be conducted under the new rules.

In the interest rate swap market, arbitrage-related opportunities are likely to exist as the most liquid over-the-counter derivatives move from bilateral voice trading to electronic order books. The anticipated deluge of new trading venues, each with a centralized order book, will initially create a fragmented market structure. Expected liquidity fragmentation across multiple SEFs and designated contract markets, or DCMs, should lead to arbitrage opportunities at the initiation of mandated SEF/DCM trading and thereafter as liquidity migrates to participant-favored venues.

Bifurcation of swap liquidity according to central counterparties will emerge as another characteristic of the new paradigm. Central order books will be CCP dependent. Differences in clearing costs for participants at each of these entities will manifest pricing differences for otherwise identical swaps. Futures contracts, particularly eurodollar and swap futures with equivalent risk characteristics — but different all-in trading costs due to spreads, margin and clearing costs — will lead to additional differences in cost to participants that will impact swap prices.

Firms employing relative value and basis strategies will have new products and markets, including swaps, swap futures and credit futures, that can be incorporated into automated execution strategies. The jury is still out on whether swap and prospective credit futures contracts will develop sufficiently deep and liquid markets to support automated strategies. However, their cost advantage versus swaps should make them an attractive and viable product for many participants. Their role will undoubtedly grow in the new paradigm.

The inclusion of new and nontraditional participants in the swap markets will amplify changes to these markets from venues, products and liquidity. These new and nontraditional participants will include active futures participants and others who are no longer restricted to International Swap Dealers Association-based bilateral relationships for trading swaps. Furthermore, multilateral execution will lead to increased customer-to-customer trading among these firms. This change will be a significant development for entities — hedge funds in particular — seeking ways to profit from their capacity to trade and warehouse risk. This dynamic has already begun in areas of the credit markets and should continue in the new derivatives market structure.

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Migration to electronic and multilateral trading in the swap markets, combined with new products, new venues, differing costs and greater participant diversity, will create myriad trading opportunities. Firms employing quantitative and automated strategies are well-positioned to exploit potential pricing anomalies and are ready to charge en masse into this latest frontier.

Sean Owens is director of fixed income at Woodbine Associates. He focuses on strategic, business, regulatory, market structure and technology issues that impact firms active in and supporting global fixed income and derivative markets.