Having access to hard-to-get information and supporting a minimal level of market transparency has traditionally been a highly profitable combination for major dealers in the over-the-counter (OTC) market. While the listed equity and derivatives markets may garner much of the public’s attention, the real money has always been in the OTC market, where global banks and dealers can use various levels of risk to create lucrative markets with fat profit margins.
Unlike in the listed markets, where agency-based trading has become the norm for most banks, the OTC market is driven by principal trading, in which major banks leverage their balance sheets to take risk positions against a diverse group of client segments. In exchange for taking the risk, however, participating dealing banks expect much higher profit potential.
Similar to the listed markets, the OTC market has also undergone fundamental changes over the last decade. Much of those changes have been around increased pressure on improving market transparency and price discovery mechanism as well as on minimizing overall risk. A core driver of these changes has been adoption of electronic trading in pockets of the OTC market. While most of the OTC market remains a manual market driven by bilateral relationships, non-standardized contracts and trading details, a growing percentage of the more liquid part of the OTC market has fully embraced electronic trading.
Significant adoption of electronic trading has taken place over the last decade, especially in the FX and fixed income markets. Both markets feature a vibrant inter-dealer market and a rapidly growing client-to- dealer market. While both markets have experienced robust growth in multi-dealer platforms in order to handle customer interactions, the FX market has experienced active adoption of single-dealer platforms until recently.
There seems, however, to be a major shift occurring in market demand for single-dealer platforms beyond the FX market, driven by various customer segments’ need for asset class diversifications and the need for banks to fully support the demands of their customers.
This article examines burgeoning single-dealer platforms with a focus on the FX market and highlights strengths and weaknesses of single-dealer platforms.
The constant push and pull between voice and electronic trading continues across all asset classes. In the OTC market, where the profit margin per transaction happens to be much higher than in the exchange-traded market, the implementation of a so- called “hybrid” approach has been widely accepted for many years. In markets where products have become commoditized with high levels of liquidity and lower profit margins per trade, electronic trading has been fully embraced by even the dealers themselves. Those markets with complex deal structures and relatively low levels of liquidity, on the other hand, remain heavily voice and manually driven.
As the OTC market continues to evolve and change, so does the typical trading profile of specific products, leading to customer adoption of the hybrid approach to accommodate both electronic and voice trading. Within the OTC electronic trading market, customers have three options:
• Multi-dealer platforms(MDPs):Very popular with certain cash fixed income products (e.g., U.S. treasuries) and FX, multi-bank platforms help customers gain access to multiple liquidity sources using a single point of access. While most of these multi-bank platforms started with a basic RFQ (request for quote) price discovery mechanism, more liquid markets, such as FX spot, real-time, and executable streaming prices, have been implemented to mimic what one could expect from equities alternative trading venues.
• Single-dealer platforms (SDPs): Single-dealer platforms are owned and operated by a single bank and provide not only execution services related to multiple asset classes, but also post- trade support, research, market data, and access to multiple asset classes.
• Inter-dealer platforms (IDPs): Inter-dealer platforms have also opened up to the customer market in recent years, but only for those actively trading firms that function more like a dealer than like a liquidity-taking customer. Traditionally speaking, inter-dealer platforms cater to dealers only; that said, we have seen customers enter the market in certain products such as FX and liquid cash fixed income.
The single-dealer platform is clearly not the only way for customers to gain access to liquidity and other bank-provided products and services. In fact, single-dealer platforms represent a very small percentage of client-to-bank interactions in certain products. Starting with FX and cash fixed income, however, the single-dealer platform is growing and threatens to become one of the dominant methods of communication for customers. As OTC trading volume continues to grow and electronic trading becomes more commonplace among less liquid products, adoption of single-dealer platforms is expected to grow even more. In addition, the increasing sophistication of large banks’ ability to segment their customer base has led to further development of single-dealer platform capabilities.
Customers have many different options when it comes to interacting with their banks. More traditional methods of communication include phone conversations and in-person meetings. Electronic communication can also take many different forms, including e-mails, instant messaging, multi-dealer platforms, and single-dealer platforms. Within this context, single-dealer platforms are natural extensions of a bank’s communication with customers and prospects, and those banks that have invested heavily into their single-dealer offerings have benefitted greatly in recent years in terms of customer retention and revenue generation.
From a technology perspective, many different components make up a robust single-dealer platform. A self-sustaining single-dealer platform is composed of connectivity to customers and third-party venues, market data distribution system, pricing engine, credit/margin platform, risk management application, and other middle- and back-office applications to both serve customers and manage the banks’ risk portfolio. The heart of the platform is the pricing engine, which needs to be flexible enough to manage and distribute varied rates depending on customer tier and execution venues. Connectivity to customers and third-party execution venues are also important, as is the ability to formulate a comprehensive, aggregated, real-time picture of the global FX market.
One major issue with single-dealer platforms is that they were typically developed to serve a single asset class. As a result, it is common to find multiple platforms that banks currently maintain to support their customers across multiple asset classes. While most banks have developed a single customer interface on top of the multiple platforms that they currently manage, it is not uncommon to find the interface to have inconsistencies across different business units as well as require multiple sign-ons.
Disparity across asset classes
Despite growing adoption of single-dealer platforms in the OTC market, a substantial disparity exists across asset classes. The FX market represents a clear success story with a significant level of adoption, currently estimated at 36% of the client-to-dealer market. In comparison, multi-dealer platforms have lost market share over the last few years. As banks continue to refine their internalization capabilities, overall growth of single-dealer platforms is expected to continue at the expense of traditional venues (e.g., EBS and Reuters) and voice business. Leading single- dealer platforms in FX would include major FX banks such as Deutsche Bank (Autobahn FX) and Barclays Capital (BARX FX).
• The diversity and complex nature of products within the fixed income market;
• Lack of liquidity in most fixed income products;
• Continued dominance of voice trading; and
• Strong adoption of multi-dealer platforms, such as Tradeweb and MarketAxess.
Despite the existing obstacles to adoption, banks have become more active in recent years in building up their fixed income single-dealer platform capabilities to move beyond research and analytics to include transaction capabilities. The focus is especially prominent in the rates market.
Benefits of single-dealer platforms
The launch of multi-dealer platforms made sense for the OTC market for many reasons. First, instead of calling four to five dealers for prices using an RFQ mechanism offered by multi-dealer platforms, customers were able to gain access to multiple live prices via a single connection.Secondly, pitting dealers against other dealers for customer business also gave multi-dealer platforms the positive effect of putting downward pressure on pricing. Finally, by comparing multiple quotes at once, multi-dealer platforms also provided customers a complete audit trail of data that can be used to justify best execution.
On the negative side, multi-dealer platforms are typically single asset class-centric, meaning that customers would need to access many multi-dealer platforms in order to trade various asset classes on multi-dealer platforms. In addition, depth of liquidity and competitive pricing are big question marks, especially in venues with low levels of liquidity. Still, multi-dealer platforms have played an important
role as one of the essential distribution channels for banks over the last 10 years. Single-dealer platforms too have become a vital part of the overall electronic distribution strategy of banks seeking to reach and build relationships with customers.
For banks, the following facets of single-dealer platforms highlight the importance of operating them:
• A single point of interaction with clients: Probably the most important facet is the fact that single-dealer platforms enable banks to communicate directly with clients (if done correctly, that is, through a single interface across all of their major business units). While multi-dealer platforms continue to be an important channel for customer interaction for individual banks, a robust single- dealer platform can minimize the potential disintermediation that can occur between the bank and its customer.
• Deepening relationship with clients: By capturing and analyzing the way customers interact within the single-dealer platforms, banks can develop a full profile of their customers and help deepen their relationships.
• Internal efficiency: By creating a truly integrated single-dealer platform with single sign-on capabilities that provide access to all of their major business units, banks can capture internal efficiency and fully leverage the internal IT assets they have developed.
• Speed to market: Single-dealer platforms can help banks quickly launch new products and services for customers. Relying on third-party venues such as multi-dealer platforms can run into the third-party venues’ own development queue, which may not coincide with an individual bank’s customer demands.
• Increased ability to customize: Single-dealer platforms can also help banks customize services and products for different types of customers. For example, for price dissemination, banks can choose to provide the RFQ mechanism for its corporate customers or streaming real-time live pricing for more actively trading customers.
For customers, single-dealer platforms provide the following advantages:
• Deeper pools of liquidity: Most customers will find that going directly to the source of liquidity via single-dealer platforms will lead to deeper pools of liquidity as banks will have more flexibility in terms of showing different levels of price.
• Single point of access to multiple asset classes: Customers can potentially have a single point of access to liquidity of multiple asset classes instead of relying on multiple platforms.
• Access to value-added non-execution services: Customers can gain access to vital non- execution services, such as research, analytics, and cross-margin services, by leveraging single- dealer platforms.
• Improved customer service: If executed properly, customers can expect enhanced customer service via a single-dealer platform; banks will have a better understanding of an individual customer’s basic requirements based on information captured through past interactions. A single-dealer platform allows banks to respond much more quickly and with customized services to ensure the needs of customers are met in a timely manner.
As OTC markets continue to grow and present customers with increasing complexity, banks have relied on developing multiple distribution channels to ensure that a wide variety of customers can efficiently access different products and services. Single-dealer platforms are a crucial component of this multi-pronged approach, along with multi-dealer platforms and more traditional methods such as phone and in-person meetings. As one of the banks interviewed for this report intimated, banks would need to adopt smoke signals if customers wanted to communicate through them. While obviously made in jest, the statement emphasizes the importance that banks develop and maintain customer relationships through many different means. Single-dealer platforms have come a long way since their inception, typically starting as an informational platform. In the FX market, single-dealer platforms have become the most dominant form of transactional channel. While still lagging behind, single-dealer adoption in the fixed income market is gradually gaining traction. Aite Group expects that IT spending in single-dealer platforms at the end of 2010 will be US$1.5 billion.
As regulatory changes push the OTC market toward more structure and enhanced transparency, the role of single-dealer platforms will no doubt increase, ensuring that banks can continue to develop and maintain long-term relationships with customers in an increasingly volatile and uncertain marketplace.