Looking at the derivatives space, trading at present is conducted in two distinct but loosely linked market domains: the D2C (dealer-to-client) domain where all trading takes place between the “original” investor/client and their natural trading counterparty (the bank), and the D2D (dealer-to-dealer) domain where banks offset some of their D2C positions with each other.
It is difficult to exactly quantify the ratio between the D2C and the D2D activity in any specific contract or asset class; however it is reasonable to estimate a range of 2:1 to 5:1. For each two to five trades between a client and the bank, the same bank trades once with other banks, warehousing the difference and managing the associated risk.
The long period of dominance banks have enjoyed because of their position at the crossroads of derivatives trading, may be abruptly coming to an end due to the rules to be introduced by the Dodd-Frank Act of 2010 in the USA and MiFID II in Europe. These rules will ban single dealer platforms and push execution of clearable instruments to external venues.
Should the rules take the shape and form currently proposed by the regulators, the banks would no longer be able to offer the same “risk transformation” service as they do today. Instead they would have to develop an alternative business model. They would need to leverage their client relationships in some alternative way and “agency” models are increasingly discussed as a substitute to the current market making model. This transformation will inevitably lead to SEF aggregation as the banks develop tools to provide their clients with an overview of the liquidity and trading opportunities available across the market.
Agency, as opposed to market making, means losing most of the greatest source of income: the bid-offer spread. Instead it will need to be replaced with a myriad of agency-related services hopefully amounting to the same revenue stream. In the proposed new world, the agency role also means that the leading SEFs will become the most valuable currency after buy-side clients. The banks will need to select SEFs and OTFs (or MTFs) carefully and work collaboratively with them to morph the loosely linked domains described above into a tight, efficient, interconnected and heavily codified marketplace.
Looking beyond the specific issues banks are facing, once they start operating with SEFs and OTFs both for their own portfolio and acting as agents, the D2C/D2D ratio will probably become a very high number because banks will not be able to warehouse risk as they do now and the D2D component will shrink relative to the D2C one.
In these circumstances the SEFs/OTFs would increasingly attract both D2D and D2C flows and reduce the distance between the two almost to the point where they collapse into each other. These new marketplaces would offer a variety of trading practices and protocols inherited from both sides, and benefit from the innovations developed over the years by wholesale brokers in the trading workflow area as much as from the distribution and product innovation provided by the banks. Client choice and market efficiency would reach new highs.
Why would this then be different from an A2A (All-to-All) marketplace?
In this model, banks would still exert some influence over their clients’ activity by acting as prime brokers and clearing agents. They would also likely be the only trading institutions committed to pumping liquidity into the market via both D2D and D2C-oriented protocols to serve the different audiences and act as the exclusive bridge between the two worlds. The banks could therefore remain in the critical spot within the entire workflow. Even if we start to see C2C (client-to-client) flows, these would be intermediated by the banks, pointing to an evolution of the D2C model rather than a full migration to an A2A one.
Market structure for derivatives would rather be an evolution of the current D2D+D2C format, where these two spaces operate like dual stars rotating around each other and pulling a lot of gravitational power over the entire system while aggregating most of the liquidity available.
Large dealer-brokers and wholesale brokers are the natural partners in the new world envisioned by Dodd-Frank and MiFID II. They are destined to work closely together to help redefine how trading of cleared derivatives will take place under the new rules.
Francesco Cicero is head of eTrading at GFI Group