“Some markets are not meant to be electronic.” At Tradeweb, we heard this statement countless times during our early attempts to digitise interest rate swaps (IRS) almost twenty years ago. Today, the electronic portion of dealer-to-client activity in IRS has grown to around 40-45% of the total market flow in Europe, proof that institutional clients continue to embrace digital workflows, particularly in the new era of multi-asset trading.

The reason is simple, but multifaceted. Price transparency, scalability, enhanced access to liquidity, time and cost efficiencies, standardisation, as well as straight-through processing and mitigation of operational risk are but a few of e-trading’s immutable gains based on client feedback. But why have swaps taken so long to electronify given all these advantages for traders? This question has more than one answer, but the most obvious one is that the IRS market is highly complex and heterogenous, with many different flavours.

Take swaps’ primary raison d'être, essentially their ability to be customised according to investors’ exact needs. While this flexibility has helped spur their growth, it has simultaneously complicated their electronification journey. In order for an electronic IRS marketplace to offer a truly functional trading environment for buy-side clients, it needs to make available a multitude of trade types such as basis, outright, curve, butterfly, forward and International Money Market (IMM) start-date swaps, and the list goes on. Its product scope also needs to include all the key currencies and risk-free rates, and must facilitate different execution methods to cater for different market conditions. Last but not least, it should enable lifecycle events management past the point of execution. Some of those events are also extensively used proactively to reduce risk in the book through a process called compression, which comes with its own nuances and requirements.

Crawl, walk, run

To truly understand the evolution of electronic swaps markets, it’s important to acknowledge the things that needed to happen, even before the Dodd-Frank and European Markets in Financial Instruments Directive and Regulation (Mifid / Mifir) reforms, which mandated central clearing and on-venue trading for IRS products. The birth of electronic swaps trading was made possible because of a behavioural change that began to unfold in the late 1990s, when trading in US Treasuries moved from the phone to the computer screen. This milestone shift opened the floodgates for the digitisation of other currencies, products and asset classes in the years that followed, with the derivatives market among the early – albeit at a much slower pace – adopters.

When Tradeweb launched its IRS platform in 2005, we were already operating electronic marketplaces across the fixed-income spectrum: from government bonds and covered bonds to supranationals, agencies and mortgage-backed securities. This meant that buy-side traders had become accustomed to sending enquiries to multiple counterparties via the request-for-quote (RFQ) protocol, and receiving prices back from dealers for comparison. In fact, one of the defining moments in the electronification of IRS trading was when dealers were able to price a swap relatively quickly, triggered by the availability of more efficient tools for pricing and counterparty credit risk management.

The two biggest game changers, however, were regulatory reform and technological innovation. Swaps’ bilateral nature made it difficult to trade them electronically until the advent of mandatory clearing under Dodd-Frank in the US and EMIR in Europe. What happened next is history and clients started wanting to infuse the uncleared space with cleared workflow efficiencies. For instance, margin rules under EMIR drove a widespread migration of inflation swap trades into the cleared world, where posting margin is comparatively cheaper than it would be for bilateral transactions. This migration combined with RFQ execution has brought on improved pricing for market participants.

And let’s not forget the role of functionality like trade compression, which helped reduce the number of trades sitting on clients’ books at the clearing house, resulting in lower risk in the book and capital footprint. Similarly, innovative trading protocols, like request-for-market (RFM), help preserve client intent, making it easier to navigate periods of heightened volatility. Finally, tools like Tradeweb’s Automated Intelligent Execution (AiEX) have made it possible for clients to automate trades based on their own execution parameters, allowing them more time to focus on larger, more complex transactions or to react faster to market events, thus creating new trading opportunities for them.

Setting the stage for the future of IRS

As trading desks become increasingly multi-asset and the idea of a one-stop shop is gaining traction, what’s left for electronic platforms to do? Now that digitisation is more entrenched across asset classes, the next obvious step is to interconnect previously siloed markets and workflows. This is more important than ever, given that clients have now various risk outlets to manage. The key ingredient for success is to continue prioritising a ‘collaborative innovation’ approach, involving customers and incorporating their feedback through every step of the product development process. Furthermore, deploying a ‘reverse onion’ tactic can also be effective. It entails initially solving for specific, simpler workflow challenges faced by clients, the core of the ‘onion’, before adding more layers by expanding its scope and coverage to address broader use cases.

We examined earlier the significant contribution of clearing towards the commoditisation of the IRS market, assisting traders to enter swaps and take them off their books quickly and transparently. This has not been the case with the bilateral world though, where trade lifecycle management is more complex and historical associated risks still persist. This is a space worth watching, as there are several new innovations in play that – once fully fledged - could potentially generate improvements within the bilateral space, helping to drive further e-trading adoption across the derivatives market.

It is safe to say that the digitisation of IRS in the developed markets has crossed an inflection point, slowly becoming the modus operandi for both the buy- and the sell-side, despite all the challenges I have mentioned in this blog. One of the biggest benefits of electronification is the ability to digitise and, subsequently, to contextualise the workflow with data. This data, in turn, can power the sell-side’s algorithmic capabilities, allowing their business to become more scalable. Right now, our focus is on those pockets of derivatives that remain mostly manual. By using technology and guidance from clients, we believe we can lay the foundations for the IRS market to become increasingly more digital, one layer at a time.