Six new firms want to capture business now going to the OTC derivatives market. And more are coming just around the corner.

By Robert Hunter

When electronic over-the-counter trading systems such as EBS and Reuters 2000 were first unveiled, traders giddily envisioned a marketplace with perfect transparency and massive liquidity. But full-scale derivatives trading on such proprietary systems has remained a dream.

Now, a number of Internet-based facilities are being developed to bring the Internet’s scalability and cost-effectiveness to the derivatives world. Here’s a glimpse at the biggest contenders (so far).

Derivatives Net

Their creation: the Blackbird system, whose release, says Dorsch, is “imminent.” When they pull the switch, Blackbird users will be able to trade interest rate swaps, interest rate basis swaps, forward rate agreements and FRA “switches” in many currencies for many terms and structures. Only banks will be permitted to use Blackbird; Derivatives Net does not intend to hasten the inexorable move toward bank disintermediation.

Dorsch says Blackbird will offer greater transparency and more information than its competitors, showing all the bids and offers in each market—even those submitted by counterparties a trader isn’t allowed to trade with for credit reasons. Whereas Reuters 2000 and EBS function as electronic order-matching systems once credit, pricing and size details align, Blackbird only sends a trade through after the trader has double-clicked. The system also warns traders when they have placed the highest or lowest bids in the market.

Fees are assessed on a per-trade basis, and, according to Dorsch, will be “between 50 percent and 75 percent lower than what voice brokers charge.” Blackbird is written in Java and is designed to be used over private intranets, but it is being tested over the public Internet as well.

ePIT

Internet Derivatives Trading At A Glance
Company	Description	URL
Derivatives.net	An interbank system that initially will trade interest rate swaps, interest rate basis swaps, forward rate agreements and FRA "switches" in many currencies for many terms and structures, with more products in the pipeline.	www.blackbird.net
EPIT	An open system (dealers and end-users) trading exchange-listed equities, equity futures and equity options. Users have expressed interest in over-the-counter products as well.	www.epit.com
e - foreignexchange.com	An interbank system trading foreign exchange derivatives.	www.e - foreignexchange.com
credittrade.com	An interbank system trading credit derivatives, such as credit-default swaps, total-return swaps, asset swaps and credit-linked notes.	www.credittrade.com
creditx.com	An interbank system trading credit-default swaps.	www.creditx.com
Information.Internet	A dealer–client system covering equities, equity warrants, futures, spots, forwards, crosses, forward rate agreements and repos, with options and more fixed-income products expected shortly.	www.info-int.com

“I saw three major problems at the exchanges,” he says. “First, commissions were far too high. Second, we were not trading new products that the customer wanted to trade—we were creating products primarily designed for the industry to manage. Third, there was a tremendous disparity between the information in the pit and the information customers received. The customer had to climb those three obstacles in order to trade.”

Friesen’s solution: the “FIT Pit,” which he hopes will provide customers with fairness, integrity and transparency. Traders will see all the bids and offers for a given product, along with historical price data and other information on a single screen. Orders are executed by an order-matching “crossing algorithm,” and clearing is handled by customers themselves. The company is negotiating with exchanges to become what the Securities and Exchange Commission calls an exchange “facility” such as Optimark, which serves as an electronic crossing engine for the Pacific Exchange.

ePit is setting its sights on the OTC market as well. “In our business model,” says Friesen, “we created a category called a ‘pit operator,’ who is responsible for creating a product, marketing it, generating liquidity and supplying all the contextual information that is needed to have the community successfully trade that product. We’ve had conversations with OTC people who’ve said they would be interested in using our services for OTC products. Any group that wants to get together and trade a particular product—custom options, foreign currencies, any other kind of derivatives imaginable—can do so.”

In the OTC scenario, interested OTC parties would be issued a “Pit Passport,” which limits entry into the pit to those who have credit acceptance with the market-maker. The result, he hopes, will be a kind of souped-up chat room. “We’ve had talks with major electrical producers and users who want to create private trading, because they don’t want grandma shorting electricity she can’t deliver,” says Friesen. “Others have said they want to trade products without worrying about credit or delivery risk. Some may start a private trading pit, and if successful they could migrate it to an exchange pit which would be cleared and eliminate private party credit risk.”

e-foreignexchange.com

The key to the site is the “Trade Online” section, in which users can make bids and offers and obtain other pertinent information. Users list their orders and an online auction system for the orders appears automatically, allowing users to select the most attractive bids. Orders can also be filled when specific market criteria are met.

Unlike some other trading systems, e-foreignexchange.com’s chat facility allows users to make confirmations live, without a telephone call. The chat system also e-mails all conversations to users following trade completion for record-keeping, and users have the option of revealing or hiding their identities.

The site’s “Quantitative Corner” provides tutorials, Black-Scholes-Merton pricing calculators and research articles. “The rationale behind the project was to provide a better understanding of derivatives to all potential users,” says Phil Kongtcheu, the company’s president. “There’s an educational purpose behind this.” The site’s biggest advantage, says Kongtcheu, is its extensibility. Whereas other systems offer liquidity in a narrow band of foreign exchange products, e-foreignexchange.com is flexible enough to offer any product for which a user wishes to make a market. “We simply provide the medium.”

credittrade.com

The site’s main focus is on credit derivatives such as credit-default swaps, total-return swaps, asset swaps and credit-linked notes. “Institutions were telling us that the market was suffering from a lack of transparency and efficiency,” says Chris Surr, head of sales and marketing at Mutant Technologies. “The Internet is a fantastic opportunity to get around both those issues so institutions can post documentation with a trade and do all sorts of things quickly, easily, efficiently and safely.” Perhaps more important, use of the site is free; commissions are charged only when deals are completed, and credittrade.com’s fees “are designed to be the cheapest you can find.”

So far, says Surr, 150 users from 50 institutions have visited the site during its the trial period.

creditx.com

That’s where creditx.com comes in. The site will allow users to see a full range of bids and offers, and assists in the documentation process as well. “We’re not trying to emulate a traditional brokerage,” says McEvoy. “We’re bringing buyers and sellers together, aggregating disaggregated information and adding value.”

The Bank of Montreal, Pacific Life and Financial Security Assurance, and a number of undisclosed dealers have invested in the site, which will be launched in September.

Information.Internet

The system is designed to facilitate trading between a broker/dealer and its various counterparties over corporate intranets or the public Internet. Users can define any product they’d like to trade. “At the moment,” says John Ersser, marketing director at the company, “we have people trading equities, equity warrants, futures, spot, forwards, crosses, forward rate agreements and repos, and we have clients coming onboard shortly who will start trading options and more fixed-income products.”

The system may be the first Internet trading system that links broker/dealers with end-users, which could be retail clients, institutions, funds or even another banks or dealers.

Here’s how the system works: A client expresses interest in a quote based on an indicative price the dealer has placed on the system. The quote request goes back to the desk, where the dealer can do some modeling, come up with a price, perhaps spread it a bit, and put that price back into the system for the client to see. If the client is interested, he or she confirms that as an order, and the system captures the trade and sends it to the middle and back offices.

Why would such broker/dealers want to encourage their clients to trade via the Internet? Unlike other Internet-based systems, says Ersser, the system allows derivatives market-makers to control all the information their clients see, preserving their informational advantages. Murky markets will remain murky; the system simply automates the deal-making functions traditionally handled over the telephone, and can feed directly into middle- and back-office systems, allowing for quick risk management and clearing.

“There are zero processing errors,” says Ersser. “There’s no one writing out deal tickets or reprocessing or rekeying deals anywhere else. It’s total risk management, because the dealer controls the profiles of the client.”

The company charges an initial licensing fee and collects a per-trade fee as well. Ersser says GNI, Commerzbank, Societe Generale and Investech Bank are among the system’s users thus far.

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