Financial Crisis of 2008
The historic global financial markets meltdown and ensuing regulatory chaos of 2008 caused the collapse of many of the largest banks, requiring public funds to bail them out. The financial crisis propelled regulators worldwide to find ways to improve market transparency, reduce systemic risk and drive down the cost of trading through greater use of centralized clearing, pre-trade risk controls, and new trade reporting regimes.
As a result, the United States Congress drafted the most extensive overhaul of the U.S. financial system since the 1930s, the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which was signed into law July 21, 2010. The primary goal of the Act is to establish a means by which regulators can monitor, in real-time, the growth of systemic risks in the financial system and have the power to intervene to prevent the emergence of future asset bubbles and place greater controls on "too big to fail" market participants. A key chapter of the Dodd-Frank Act is intended to give regulators new powers to oversee the $700+ trillion over-the-counter ("OTC") derivatives market by increasing transparency and forcing trading into a new layer of infrastructure that provides for timely pre-trade credit confirmation, accurate trade data collection, and centralized clearing for the trading of swaps and security-based swaps.
OTC Derivatives Market Inefficiencies
The current OTC derivatives market is opaque with pricing concentrated at a small group of dealer banks. For decades, OTC buy-side market participants had no other choice other than navigating in these dark and inefficient markets. These OTC derivatives customers have grown increasingly frustrated. They are demanding greater efficiencies, better price discovery, less risk and access to a broader range of products as they seek new business opportunities and greater profits. OTC market participants are also looking to immunize their balance sheets from ever-increasing counterparty risk which central clearing solves.
While most of the financial sector incumbents lobbied aggressively to change or delay many aspects of Dodd-Frank Act that threatened their de-facto oligopoly and significant revenue streams, the buy-side market participants and the clearing institutions have welcomed and accelerated the move to clearing ahead of the final regulations. Buy-side OTC customers are taking a leading role in this market transformation by driving the CME, ICE, LCH and other clearing institutions to offer clearing of OTC derivative products.
The Drive to Central Clearing
The migration to central clearing for OTC product will improve the transparency of financial markets and the "electronification" of OTC derivative trading will spark significant changes in the way that derivative products such as swaps are traded among market participants. Interest Rate Swaps (IRS), Credit Default Swaps (CDS) and FX derivatives (CSF/NDF) collectively are a multi-trillion dollar market that are currently traded in a bi-lateral OTC manner. Moving forward, standard OTC trades must pass through a Swaps Execution Facility ("SEF") and will be required to be cleared through a central clearing house. According to a report by Oliver Wyman / Morgan Stanley, this migration to central clearing will cause approximately $270 billion in execution revenue to be reallocated throughout the global financial eco-system as dealer and interdealer broker functions are replaced by SEFs and clearing houses. The majority of that $270 billion revenue reallocation will be realized in the form of significantly better pricing to the buy side.
Previously, bilateral OTC transactions were governed by International Swap and Derivative Association (ISDA) documentation, bilaterally negotiated for each bank. This is a costly and time consuming process. Central clearing obviates the need for ISDA documentation, and is worth noting that there has never been a lawsuit filed due to a trade being "cleared". Clearing has been a driver of efficient markets in equities and futures for over 100 years – and it is now coming to the OTC markets.
Trading IRS, CDS, FX Derivatives & other Derivatives on TeraExchange
In the IRS markets today, market participants using TeraExchange and clearing at the CME will have the ability execute a number of cleared products based upon: 1, 3 or 6 month floating Libor vs. fixed legs out to 50 years in USD; 3 and 6 Euribor out to 50 years in EUR; 6 month Libor out to 50 years in GBP; 3 month CDOR out to 30 years in CAD; and 9 additional currencies rolling out in 2012. The "plain vanilla" or standard IRS product accounts for nearly 85% of all rates trading today.
In CDS, there are over 250 single-name instruments and 80 indices that are currently cleared through the ICE or CME, with more than 2,000 single-name CDS contracts coming online over the next few years. In addition, while high-grade and high-yield CDS indices are already available today, a wide range of emerging market indices and options on CDS products will be available in the near future. TeraExchange will be listing all these CDS and CDX instruments for trading.
TeraExchange will list cleared foreign exchange derivatives for execution in addition to rates, credit and energy. FX Derivatives are a $58 trillion market place, and are expected to expand in the future. On October 21, 2011 the CME announced that it began clearing services for Non-Deliverable Forwards (NDFs): US Dollar/Chinese Renminbi, US Dollar/Brazilian Real, US Dollar/Chilean Peso (began clearing April 2011).
Nine other cash settlement NDF products are being introduced in 2012: USD/Russian Ruble, USD/Columbian Peso, USD/Peruvian Sol, USD/Korean Won, USD/Indian Rupee, USD/Malaysian Ringgit, USD/Indonesian Rupiah, USD/Taiwan Dollar, and USD/Philippines Peso. The CME has also begun offering clearing services for cash settled forward foreign exchange pairs.
This expanding universe of products is being driven by escalating demand that will continue to increase with central clearing. The same migration to electronic trading and transparency are being driven by client demands in the energy and agricultural markets as well.
TeraExchange Pre-trade Credit Checks and Execution
TeraExchange has uniquely brought the mainly voice-driven OTC space into the electronic arena, providing not only full-scale execution services, but also real-time quotes on derivative instruments and full data capture across a trade’s entire life cycle. In addition, TeraExchange will meet global regulatory goals of bringing transparency, accountability and oversight to OTC derivatives trading.
TeraExchange is the only OTC central limit order book platform to provide a real-time pre-trade credit check on all order submissions; this check is controlled by the customer’s FCM (i.e. clearing member) and executes on the matching engine for instantaneous trades. TeraExchange will provide pre-trade market transparency, post-execution price reporting, and matched-trade submission for central clearing at the designated clearing houses (e.g. CME, LCH, ICE, etc.)
Full Anonymity, Lower Risk
TeraExchange’s platform is unique in that it creates an anonymous buy-side to buy-side exchange that allows participants to see and act upon real-time bid-ask quotations as well as market depth information on the products they trade. This improves execution efficiency and reduces post-trade conflicts of interpretation, a material problem under the current bilateral market construct. A liquid and transparent trading environment now exists with standardized contract characteristics and understood by all participants. From that base, two additional customer benefits are derived: simplified and audit acceptable portfolio valuations and the elimination of ambiguous interpretations of customized bilaterally-negotiated contracts. Trading will no longer be subject to subsequent litigation risk due to ambiguous bilateral documentation.
TeraDirect is a next generation cross-asset Execution Management System (EMS) for trading OTC cleared derivatives on TeraExchange as well as the equities, futures, options and other markets. TeraDirect provides comprehensive liquidity access, fast execution and built-in order management capabilities along with advanced analytics and charting, full market depth and executable real-time pricing. TeraDirect is provided at no cost to customers trading on TeraExchange.
Through "electronification" of the market, better price discovery and broader, more liquid markets for cleared OTC derivatives traded on TeraExchange, firms will be greatly enriched through the wider range of products and services.
Regulation is one driver, but it is only pushing along a natural evolution of good business practice. With TeraExchange, OTC derivative market participants can be confident that the markets they trade are fair, that their executions are firm, and that their trades are final.
Fair, Firm & FinalSM with TeraExchange