Once there were two pre-trade credit checking hubs for swaps. Now there is only one left standing.
Time for fund managers to ask their clearing agents some tough questions.
Futures commission merchants (FCMs) are backing Traiana’s pre-trade credit checking hub over Markit’s, which was forced to shut down for lack of traffic. Concerns about the potential for Traiana abusing its new monopolistic role are understandable. After all, with Traiana as the sole provider of a centralized mechanism for FCMs to link to multiple swap execution facilities (SEFs) simultaneously, some fund managers are worried that it might decide to increase fees charged FCMs. The added costs could ultimately be passed down to the end customers. Likewise, there would be no alternative provider if Traiana decided to eliminate some of its functionality or change its terms of use.
But from what swap consultants tell FinOps Report, fund managers should be more concerned with reviewing just how their FCMs are handling their pre-trade credit check process through Traiana and the SEFs, what fees the FCMs are charging to do so, whether such fees could be changed, and what alternatives are still available. The hub approach to connectivity for pre-trade credit checking isn’t the only game in town. FCMs can always link to the SEFs directly and some already do.
“It’s the perfect opportunity to revisit just how the pre-trade credit check process works and what it costs,” advises one swaps consultant. “Fund managers have taken for granted that FCMs know what they are doing, but they shouldn’t let them be the sole decisionmakers.” Fund managers also need to step up to the plate.
Opening up the discussion on the pre-trade credit check could ultimately lead to additional unrelated questions on extra services FCMs can offer, the benefits to fund managers, and how they would be billed. FCMs typically serve as both executing and clearing agents linking fund managers to swaps execution facilities (SEFs) –electronic trading platforms accredited by regulators — and clearinghouses that are required for processing swap transactions. Clearinghouses serve as parental middlemen ensuring each counterparty to the trade is made whole in case the other goes bust
An FCM’s serices can range from the basics to more advanced pre-trade analytics, data aggregation, independent valuatons, cross-margining, what-if scenarios, and middle-office collateral management. Pre-trade credit checks are part of the basics.
Checking Out the Options
Why should revisiting the pre-trade credit check process be a top priority for fund managers? At minimum, because they can’t afford to have their FCM get it wrong. The US Commodities Futures Trading Commission (CFTC) requires clearing brokers, called FCMs in the US, to determine if their fund manager clients have breached their credit lines before executing trades through an SEF and processing them through a clearinghouse, if deemed centrally clearable. Clearing brokers have sixty seconds after a trade order is sent to an SEF to confirm whether the fund manager’s credit is okay. A clearinghouse must then accept the trade for clearing within another sixty seconds.
If it can’t be cleared, it can’t be traded on an SEF. FCMs typically allocate a certain amount of credit to each fund manager customer and should the trade ultimately have to be unwound, it is bad news for the FCM and fund manager who will have extra costs to incur. That would be a shame, if the credit were available in the first place.
Until now, Traiana and Markit’s hubs have operated as a duopoly in the pre-trade credit check process. Traiana’s CreditLink started life as a pre-trade credit checking facility for foreign exchange, futures and fixed-income trades. It added credit default swaps and interest rate swaps in January 2013. Well-known as a middleware provider for swap contracts, Markit launched Credit Centre two months later. Both obviously wagered on a growing market, but as it turned out, there was only enough business for one of them.
“We can confirm we have closed down Credit Centre, our pre-trade credit checking platform,” says Markit’s press department in a statement to FinOps. “Two years ago, as the industry prepared to move to electronic trading of OTC derivatives, we anticipated the need for an ultra high-speed hub to create clearing certainty. While Credit Centre was designed to handle hundreds of thousands of orders per second, the market has not evolved to that level of trade frequency.”
Markit would not disclose the number of FCMs using Credit Centre. While declining to comment on the competition, Nick Solinger, head of product strategy and chief marketing officer for Traiana confirms that 16 FCMs are using Traiana’s pre-trade credit checking hub to verify some or all clients’ credit limits across 15 SEFs. Those FCMs, in turn, service several hundred fund managers, introducing brokers and other trading firms which use swaps. Solinger says he doesn’t know how many of those were using Markit’s pre-trade credit checking hub, but there could potentially be some overlap.
Pushes and Pings
Should FCMs connect to SEFs directly, they can rely on one of two approaches– the push or more popular ping methodology. In the push model, an FCM can communicate with the SEF to provide it with credit limits for each fund manager client. The SEF would alert the FCM if the fund manager has exceeded its credit limit. In the ping methodology, the SEF routes an order from the fund manager to the FCM designated by the asset manager to “ping” or verify whether it has passed a credit limit.
Naturally Solinger is quick to point out the advantages of having the swap transaction pass through a hub for pre-trade credit checking. Cost is one, he claims. Granted, an FCM would have ongoing fees to use a hub, but the direct approaches would be more expensive for an FCM to implement up front, swaps technology specialists tell FinOps.
What’s more, the hub is more flexible, says Sollinger. It allows for both the ping and push approach to pre-trade credit checking, as well as supporting multiple trading methodologies. “Our CreditLink service allows credit limit checks for SEFs relying on the request for quote (RFQ), central limit order book and even voice request for quote services,” says Solinger. “We have created a sophisticated set of capabilities to give FCM clients a realtime picture of limits. So even if voice trading its used, it would still be updated in their limits.” So far, the most popular form of trading is via the RFQ model. Markit reportedly lost out when it bet Credit Centre’s fortunes on the central limit order book methodology.
What about fund managers who only want to link to a one or two SEFs. FCMs, says Solinger, have tied their internal risk systems into Traiana’s credit hub so that FCMs can net trading activity in real-time, potentially providing offsetting benefits between certain products and between voice and electronic trading even if a client is only using one or two SEFs.
Bottom line: regardless of whether the hub or direct approach is taken to pre-trade credit checks, fund managers have a lot at stake financially. They are relying on their FCMs to ensure that function is operationally efficient and cost-effective, as well as managing their credit limits to the fund manager’s benefit. Of course, the same applies to the other trading and post-trade processes that FCMs offer. Fund managers that ask the right questions are more likely to the services that lead to more efficient and cost-effective workflow, a far better outcome.
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