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TeraExchange: On The Case

Published in Automated Trader Magazine Issue 25 Q2 2012

What do you do if you're an OTC trader and you hear that your market will have to move to centralised clearing? Moan? Bury your head in the sand? Not if you're Christian Martin, instead you immediately set about founding a marketplace for OTC products with links to multiple CCPs. Andy Webb talks to the CEO of TeraExchange just a few days before its "go live" date about the democratisation of the OTC world.

Christian Martin, Co-founder and CEO

Christian, how did you come to co-found the exchange?

I've been about 20 years in the industry with organisations such as Merrill Lynch and Bank of America. In 2008, I started a proprietary trading group - Spring Trading - that was active in the derivatives area and used technology developed in house for its trading activities. About two and a half years ago when my co-founder Lennie Nuara and I heard that OTC products would be moving to centralised clearing we realised that this had enormous potential in various ways - transparency, trading activity, new trading strategies and new market participants to name but a few. Due to a significant gap in the marketplace for electronic trading and analytical tools for OTC derivatives we had already assembled quite a lot of the necessary technology for use by Spring Trading. The core technology was an event-based platform, developed by Daniel Droste (now our CTO) about eight years ago, and we started using it at Spring some four years ago. Given that we had so much of the technology we needed already, completing the loop by building an exchange for OTC products seemed the obvious course. Once the CFTC, SEC and other regional regulatory bodies finalise rules pertaining to these markets, we will apply to be a Swaps Exchange Facility (SEF) in the U.S., Organised Trading Facility (OTF) in the EU, as well as other regionally-regulated structures as applicable.

So what does TeraExchange actually consist of?

The exchange itself is a central limit order book (CLOB) for any OTC instrument that can be cleared through a CCP. That is then wrapped in a proprietary cross-asset execution management system (EMS) called TeraDirect that enables execution of both OTC instruments and any underlying cash or futures products that you might use for strategies such as spreading between (for example) Eurodollar futures and an OTC interest rate swap. The technology is housed in various Equinix facilities located near major trading centres. Users can also connect directly to our exchange using FIX and FAST FIX if they prefer. We don't charge any licensing fees for using TeraDirect if customers are trading OTC derivatives, which we feel minimises any barriers to new users entering the OTC market place.

Leonard T. Nuara, Co-founder and President

Leonard T. Nuara, Co-founder and President

TeraDirect also incorporates a C++ algorithmic engine that enables the deployment of rules-based trading. In the case of spread traders this can be used to manage an unlimited number of legs on either side. For those who prefer to trade off charts there is the facility to display both OTC and underlying instruments, as well as to click trade from within the chart (though conventional buy/sell tickets are also available as well as trading directly from Level II screens).

What about connectivity between your EMS and other trading venues? Do you assist users in setting that up?

We actually handle all the connectivity with other exchanges and brokers on users' behalf because we want to make it as easy as possible for people to trade OTC products. To that end, we already have the plumbing in place for the domestic US exchanges (equities and futures) and are preparing connections to other liquidity destinations. Our ultimate objective is to deliver a turnkey solution to anyone interested in trading cleared OTC and other underlying products electronically.

How big is your technology team?

Our CTO is based in Germany where we have a subsidiary that is our technology arm. In terms of full-time equivalent employees dedicated to the developing and running the technology, we employ approximately 10 programmers and engineers. As I mentioned earlier, our core technologies have been in development for several years, well prior to the regulatory mandates, so the man-hours dedicated to this project to date have been significant. Going forward, we're fortunate in that because we don't do clearing, but just connect to CCP entities that do, our overheads are lower. Clearing is a very heavily regulated and operational task, so because we don't have to deal with that, we can function with a leaner technology team.

What about scaling of technology as volumes (hopefully) grow? How will you handle that in terms of matching engine capacity and extensibility?

We estimate that we have enough capacity in place to support hundreds of substantive users as from day one and have also leased multiple cages at Equinix to cater for physical expansion, allowing us to ramp up very quickly as demand requires. As to extensibility and load balancing, our technology and leased capacity allows us to scale infinitely by splitting more active instruments onto separate hardware, the same method used at all of the major exchanges.

What about the inevitable latency question?

We anticipated the latency conversation, which is why we focused on data centre locations adjacent to the major underlying markets, but that was also because we felt it delivered the greatest concentration of liquidity and access across multiple markets. In view of the way OTC instruments are traded today, latency isn't currently really an issue, but we can see that in a few years it probably will be. So when establishing TeraExchange we were trying to anticipate that and deliver an offering that had as tight a loop as possible from the latency perspective. For example, you are not obliged to transmit orders locally from the TeraDirect front end, you can also deploy trading models on servers within the data centres we are located in to further minimise the latency.

What's your philosophy in determining which products to list?

At a very high level, if the CCPs list OTC products as available for clearing - then we'll list them for trading on our platform shortly thereafter.

When listing OTC product, we'll always attempt to deliver access to complementary listed instruments that a trader might want to use for trading spreads or other inter-market strategies. Our objective is bring everything together to a single point of analysis and execution.

Leonard T. Nuara, Co-founder and President (left), Joseph Kenny, SVP and Head of Credit Derivatives Sales (middle), Alex Krunev, Associate (right)

Leonard T. Nuara, Co-founder and President (left), Joseph Kenny, SVP and Head of Credit Derivatives Sales (middle), Alex Krunev, Associate (right)

As regards the OTC products we list, we will be starting with plain vanilla interest-rate swaps and forward starting standardised interest-rate swaps, plus fully customised interest-rate swaps with forward starting effective dates and user-definable end dates. Out of the gate, we will also be listing credit default swaps (CDS) and CDS Indices. Obviously we are first solving for the 80 per cent of the market that is standardised, rather than the approximately 20 per cent that is non-standardised. Nevertheless, we feel that offering a degree of customisation from the outset is important, which is why we have signed up two market makers to the platform with the express purpose of them making markets in off the run dates.

In the near-term, we'll be adding new products as the CCPs add them for clearing and list them alongside relevant products from other venues, such as non-deliverable forwards with currency futures and equity swaps with S&P futures.

So how quickly can you list new products?

If a CCP announces it will start clearing a new product, the time it takes us to support that product on our platform depends on whether we are already connected to that CCP. If we are, it will take two days, but if not it should take approximately three weeks to connect to them. However, we would also have to comply with their certification process, which is not in our control as regards timeline.

Which CCPs are you connected to so far?

CME is live and ready, LCH Clearnet and ICE should be coming up shortly - but we obviously also have plans to expand globally, so are also looking to put connections in place with European and Asian CCPs. Though we definitely intend to have a global presence, the specific connections we make will inevitably depend upon the balance between the cost of connectivity and the needs/appetite of our installed trading user base.

What about trading members? Who do you see as potential participants?

Our mantra is that we are an all-to-all platform, though our value proposition leans towards the buyside and other end users such GSEs. One of the most important elements in this is a pre-trade credit check (which we have named TeraCheck) that has never been offered before for OTC products because everything was previously negotiated bilaterally. Traders have come to us with a CCP clearing member (also known as a futures commission merchant "FCM") to whom we extend access to a risk engine that mandates that they provide traders with limits on our platform. (The risk engine sits on our matching engine, so from a latency perspective it effectively doesn't exist.) Therefore, if you have a certain number of dollars deposited with your FCM then you can come and trade with us straight away.

Marti Tirinnanzi, SVP and Head of GSE Sales

Marti Tirinnanzi, SVP and Head of GSE Sales

This risk model is core to our business - without the pre-trade credit checks, our central limit order book would be hollow in that it could never be more than a block of indications of interest. Instead, any trader authorised on our platform knows that any price they see on the system is immediately tradable because the person on the other side of that price has also already passed the same pre-trade credit check. As a result, a whole new segment of the trading community can now for the first time directly participate in the OTC market place.

But how small might these new participants be? For example, what are your minimum order sizes?

This will probably never be a retail type trading platform, but it will be accessible to all categories of professional trader. Our notional, round lots and increments will be in line with the way OTC products trade today. For example, we will have a minimum of USD 1 million in interest-rate swaps, with round lots of the same amount and increments of USD 100 thousand. We'll have similar minimum, lot and increment sizes for other instruments such as credit default swaps. We feel that these sizes will still be accessible for mid-size hedge funds and proprietary trading groups.

From left to right: Marti Tirinnanzi, SVP and Head of GSE Sales, Christian Martin, Co-founder and CEO, Joseph Kenny, SVP and Head of Credit Derivatives Sales, Mike Felix, Director of Marketing, Alex Krunev, Associate

From left to right: Marti Tirinnanzi, SVP and Head of GSE Sales, Christian Martin, Co-founder and CEO, Joseph Kenny, SVP and Head of Credit Derivatives Sales, Mike Felix, Director of Marketing, Alex Krunev, Associate

Furthermore these numbers will only apply to single legged one sided positional trades. If you are trading spreads or other hedged strategies, then the value at risk will be much smaller and substantial margin relief from the CCPs will kick in, up to 85 per cent with treasury and eurodollar futures at the CME, for example. This makes it something of a sweet spot for FCMs, because as long as your risk is being managed appropriately - which it can be on our execution management system - then you can extend margin in a highly controlled way to allow the execution of potentially huge volumes in hedged trades. We've had several conversations with FCMs about clients who will be given one account number for trading interest swaps in isolation and another if they are going to trade them versus a hedged product.

Apart from the trading community, this model presumably also has something to offer other types of participant such as corporate treasuries?

Yes - because the transparency and certainty of pricing is of universal value. This is all about democratising OTC execution, so it doesn't matter who you are. Whether you are a corporate treasurer or a fund manager you can still see and trade on the same price instantly. It is a completely level playing field because everybody who trades on the platform has to participate via their FCM and operate within their credit limits through our risk engine.

For those such as corporate treasuries this adds a lot of value in terms of not having to call around dealers for prices, but also in that they are not locked in to a particular dealer if they subsequently need to unwind the trade, which under the bi-lateral model carries significantly higher costs for them versus entering a position, since they are already locked into that specific dealer. Unlike their current situation, this sort of participant will now really be able to achieve best execution, both into and out of a position.

Daniel Droste, Co-founder and CTO

Daniel Droste, Co-founder and CTO

The data that the exchange generates will presumably by definition be unique?

Exactly. By implication, any data from the exchange will be valuable because there has never before been a central limit order book with pre-trade credit checks for OTC instruments. That gives a certainty to the marketplace that allows the accumulation of meaningful bid/ask tick data, as well as executed trade data. There is also a complementary data set that derives from our ability to bring in exchange traded products alongside our OTC products in terms of the basis that exists between those asset classes.

Our intention is obviously that participants will use these various data types for developing automated trading models that will be deployed on the exchange and will in turn themselves further enhance liquidity. However, historical data will also add value for those such as corporate treasurers wrestling with accounting reporting and trying to satisfy their fiduciary responsibility in terms of the corporate balance sheet and shareholders. The same applies to others such as hedge fund managers who need firm prices to mark the net asset value of their portfolios to market.

Finally, there is also a regulatory opportunity here. The Swaps Data Repository (SDR) rules provide that in year one you have to report within thirty minutes, year two within fifteen minutes and immediately in year three. But regardless of the rules, we will be providing this data in real-time for those who subscribe to it.