Hedge funds have gained plenty of notoriety for the high-pressure tactics they employ to restructure companies and reshape their boardrooms. Now hedge funds have begun to battle the exchanges where they trade. Their goal is to trim costs and speed up transactions by cutting out broker-dealers and plugging their algorithmic trading programs straight into electronic order systems.
For the past year a group of hedge funds, including Chicago’s Citadel Investment Group and DRW Holdings, Madrid-based Vega Asset Management and New Yorkbased D.E. Shaw & Co., has been lobbying for direct access to MTS -- the primary electronic platform for trading in the $5.4 trillion pan-European government bond market. These firms are pushing MTS to follow the lead of Swapstream, the subsidiary of the Chicago Mercantile Exchange that provides a trading platform for interest rate swaps. Swapstream announced in April that it would create dealer-to-client trading in response to demand from hedge funds and other professional traders.
Direct access can provide big savings. At MTS hedge funds currently must trade through the platform’s 25 member brokers. As a result, the price to trade bonds worth E1 million ($1.3 million) is estimated to be more than E15 per transaction, according to “Improving Efficiency in the European Government Bond Market,” a November 2006 report by London-based broker-dealer Icap. A similar-size trade on Icap’s BrokerTec or Cantor Fitzgerald’s eSpeed, two New Yorkbased bond trading platforms that hedge funds can access directly, costs about E3.
So far MTS, which is majority-owned by NYSE Euronext and Borsa Italiana, has denied hedge funds direct access to its platform. Its management is torn between embracing new members that could improve trading volumes and profits and pleasing its existing client base -- a group that includes the world’s largest investment banks.
As a condition of membership, MTS requires primary dealers to act as market makers for at least five hours a day. That means banks must commit to displaying buy and sell quotes for all the bonds on the platform. Though market making is typically a money-losing prospect, banks have taken on the role in exchange for being first in line to syndicate new issues, participate in privatizations and arrange complex derivatives contracts.
Hedge funds, however, are pushing for permission to trade on MTS without assuming market-making responsibilities. And MTS recently indicated that it may ultimately let that happen. “Although the supervisory board generally supports the view [that] it is desirable to liberalize the access of the market to third parties as a way to enhance liquidity,” the trading platform operator said in an April statement, "[the board] concluded that further work is needed to address some of the concerns arising from this opening.”
Not surprisingly, MTS’s primary dealers are horrified by the prospect of a two-tiered system in which they would bear the costs of providing liquidity while hedge funds would reap the benefits. “Dealers will withdraw liquidity if that happens,” warns Mark Austen, executive director of the European Primary Dealers Association, an arm of New York’s Securities Industry and Financial Markets Association. In an effort to level the playing field, the EPDA is pushing to eliminate MTS’s market-making requirements. MTS, its primary dealers and the hedge funds fighting for direct access to the platform all declined to comment on their discussions. But a source at MTS says that a resolution could come as soon as the end of this month. If Swapstream’s recent decision to open its doors is any guide, hedge funds could soon notch another victory.
