When we saw Markit Group buy SwapsWire and then BOAT in quick succession, we knew it was time to take a closer look at the aggressive British entrant into the U.S. derivatives processing market.
Founded in 2001, Markit started out as a provider of independent credit derivatives pricing. Its derivatives indices, such as ABX and CDX, have become critical in firms' struggle to accurately determine the value of outstanding derivatives contracts whose underlying assets may be murky. ABX, for instance, tracks the performance of a set of credit default swaps based on U.S. subprime home loans (the derivatives prices themselves are provided by a consortium of 16 investment banks).
It is widely understood that Markit's indices effectively are the only independent means (other than complex mathematical models that cannot take into account factors such as underwriting quality) available to estimate the value of certain types of derivatives. But not everyone is a fan of the indices.
"They're fallacious because they reflect an environment that doesn't exist," contends Dick Bove, analyst at Punk Ziegel. For instance, Markit's CMBX index of commercial mortgage-backed securities recently reflected a 6 percent to 8 percent imputed loss in U.S. commercial real estate when the actual loss was a quarter of 1 percent, according to Bove. "People buying the securities are estimating a far worse disaster than is actually occurring," he says. Accounting rule FAS 157 requires banks to mark certain products down to the implied value of the indices, even if they still are performing well, Bove notes. What firms should do, he believes, is value securities according to how well they actually are performing, rather than based on indices that reflect only what securities buyers think.
Markit concedes that its indices are not perfect. "What an index tells you is where the derivative category is moving; to some extent, that's a symptom rather than a cause," responds Jeff Gooch, EVP and head of trade processing and valuations at Markit. "It helps, because it gives you something to watch. And it does, to a certain extent, reflect some liquidity issues as well as everything else that goes into valuing these products."
Markit also provides a Reference Entity Database (RED) Service -- a set of business entity identifiers to which dealers can refer in order to standardize documentation and avoid mistakes. RED has become so essential to the credit derivatives market that the DTCC has said it will soon start rejecting contracts coming into its Trade Information Warehouse that lack RED coding.
A Thirst for Operations
Markit began its foray into derivatives automation in May 2006, when it acquired White Plains, N.Y.-based Communicator, which offered an OTC derivatives processing platform for trade confirmation, pricing, valuation and trade lifecycle events (the product has been renamed Markit Trade Processing). "We made a very definite decision to get into the processing space," recalls Gooch, who previously ran global OTC derivatives operations at Morgan Stanley.
"The general health of the OTC markets is very dependent on processing efficiency," he continues. "If the industry collectively is going to sort out the problems in derivatives processing, it's going to need to move the bulk of the volume for confirmation in those markets over to electronic platforms."
According to Gooch, across all asset classes, less than half of current derivatives contracts are confirmed electronically. "We think there's going to be a need for a lot more electronic solutions in the processing area," he says.
Last November, Markit announced its agreement to buy SwapsWire, an electronic confirmation network for dealers, interdealer brokers, prime brokers and buy-side firms to exchange trade data and confirm OTC transactions. Gooch believes the move will help electronic adoption by providing some needed vendor consolidation.
"If you look at the current landscape, it's split across a number of vendors -- SwapsWire being one very big player; DTCC with their DerivServ offering being another; and also Markit's Trade Processing Platform. Then there's a number of very small firms, such as TZero. ... That's confusing to people," Gooch explains, adding that system integration difficulties often arise for firms that are connected to multiple vendors.
"We believe there's a need for consolidation in this space -- that the dealer community needs to have some influence and control over what's going on, and Markit is 70 percent owned by major dealers," Gooch adds.
Markit specifically chose SwapsWire, according to Gooch, because the platform is front-office oriented, suiting Markit's natural client base. "It gets the traders involved with resolving the issues on a given trade, and it does so very quickly after execution," he says.
It also helped that SwapsWire was another dealer-owned consortium that, incidentally, shared many of the same dealer owners as Markit. "There's very little geographic or product overlap, which is fantastic in terms of creating synergies," Gooch notes.
Head-to-Head With the DTCC?
The SwapsWire acquisition could bring Markit head-to-head with the Depository Trust & Clearing Corp., which provides clearing, settlement and information services for equities, corporate and municipal bonds, government and mortgage-backed securities, money market instruments, and over-the-counter derivatives. But, Gooch notes, DTCC is owned and controlled by the same banks that own and control Markit, and the two organizations have a shared agenda.
"Our current trade processing platform is the biggest single provider of trades to their platform -- we send them 30,000 to 40,000 trades a month," Gooch relates. Although Markit and DTCC have individual products that compete with one another, he says, that is being worked out.
But while Gooch says Markit and DTCC "have a very active relationship in both directions," he adds, "I'm hoping this deal with SwapsWire doesn't change that."
According to a DTCC spokesperson, "We have a strong, long-standing relationship with Markit, as we do with a host of complementary service providers, and we look forward to continuing to work with them to enhance operating efficiencies and reduce operational risks in the OTC derivatives market. For example, we built our Trade Information Warehouse -- the centralized global repository and post-trade processing infrastructure for servicing credit derivatives contracts -- with an open architecture to enable access by third-party service providers, including Markit and SwapsWire."
The DTCC automates the clearing of credit derivatives trades, of which 90 percent now are handled electronically. But only about 20 percent of equity derivatives and 40 percent of interest rate derivatives trades are electronic -- both types of trades that SwapsWire processes. "We need to try to convince those people that are on paper to move to automation, particularly in equities," Gooch insists. "Otherwise, collectively, there's going to be a problem."
Markit Predictions
So what's Markit's road map for getting there? According to Gooch, major initiatives include growing the company's footprint in the equity space and leveraging its January acquisition of BOAT, a platform for the collection and distribution of European OTC pre- and post-trade information.
Markit also will expand its valuation products. The company is working with six investment banks to develop a platform that will aggregate the banks' and Markit's derivatives pricing data to help institutional investors and fund managers value OTC derivatives and determine portfolio performance. Markit aims to launch the platform, Markit Valuations Manager, in the second half of 2008 with coverage of bonds and derivatives. It later will be expanded to include more banks and all major cash and derivative asset classes, the company has said.
Publish Date: 17 March, 2008
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