It was, perhaps, not supposed to be like this. When on that fateful September day in Pittsburgh in 2009, the leaders of the G20 nations announced that “all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate”, little did they realise the Pandora’s Box that they were opening.
Two years on and the industry is in the process of a revolution. The G20 mandate has led to the birth of new and adapted concepts of trading platforms as regulators grapple with the micromanagement of the G20 mandate, the full implications of which were clearly not thought through. But, like it or not, a new world is approaching. In the slightly paraphrased words of the 16th Century reformation theologian Martin Luther: “here we stand, we can no other”.
So where do we stand? Well, that depends where you are looking down from. Across the G20, countries are looking at ways of introducing electronic platforms for the trading of swaps and other OTC derivatives. The reforms are furthest along in the US and Europe. On both sides of the Atlantic regulators have been squirreling away to come up with a workable concept that would meet the G20 mandate. Last month, the EU published the blueprint for its model joining proposals from the US on theirs.
New platforms
In the US, the CFTC and SEC have proposed the establishment of Swap Execution Facilities. These are broadly defined as “a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce”.
In Europe, the EU has proposed the establishment of Organised Trading Facilities. The Markets in Financial Instruments Regulation defines an OTF as: “any system or facility, which is not a regulated market or MTF, operated by an investment firm or a market operator, in which multiple third-party buying and selling interests in financial instruments are able to interact in the system”.
There are key differences in definitions, which we will come to, but the purpose of both of these new platforms is to provide a facility through which OTC derivatives can be traded electronically and multilaterally. The multilateral nature of these new platforms is important as through increased transparency, regulators aim to create a more efficient market.
If successful, this should ultimately benefit the market. A report by Tabb Group found that nearly all of the 140 market participants surveyed believed that SEFs would improve the swaps market as a whole. The same study found that 75% of respondents believed that notional turnover of OTC derivatives would increase as a result of the introduction of SEFs.
Steffen Gemuenden, chief executive of RTS Realtime Systems Group, says: “Smaller firms that previously could not access OTC markets will now have the ability to trade these instruments in an electronic fashion with central clearing.
“In addition, firms that have already been trading OTC products now have the ability to achieve greater transparency and enjoy the safeguards associated with a cleared market. This will create new trading opportunities while increasing liquidity to the marketplace. All this will create even more transparency and help regulators achieve their goal of reducing systemic risk.”
However, not all in the market agree. Steve Grob, director of group strategy at Fidessa, says: “The majority of exchange traded contracts come out of the OTC marketplace when sufficient liquidity in a contract is reached. The OTC market is a kind of R&D lab for the exchanges, that is where they look for new product ideas.
“The reason things are traded OTC is because that is where they are traded best. Rather than fuss around in detail about which contracts should or should not be traded on centralised platforms, which is almost impossible to do, regulators on both sides of the Atlantic should concentrate on the path to electronic trading, not mandating the detail. Make electronically traded and cleared contracts the most benign environment to trade.”
Indeed, the move to swaps trading on markets is already well underway. Over the past 18 months, both the Eris Exchange in the US and Plus Derivatives in the UK opened their doors for business. Eris offers exchange traded swap contracts, reducing the number of variables in traditional OTC swaps in order to standardise the contracts to trade while Plus offers a Swap Index Contract that enables exposure to interest swaps based on the FTSE MTIRS Index Series. The contracts can be traded OTC before being sent to Plus for the exchange wrapping and clearing with LCH.Clearnet.
Crucial differences
While the definitions of SEFs and OTFs may appear similar, there are some crucial differences in their structure in the current writing of the regulations. OTFs are much broader in their scope. They are designed not just for the trading of swaps but of equities, commodities and other derivative contracts.
OTFs have been born out of Multilateral Trading Facilities, electronic trading platforms that have thrived since they were introduced by the original Mifid in 2007 and spawned Chi-X and Bats Europe’s assault on the European equity markets.
Another key difference between OTFs and SEFs lies not only in the scope of asset classes that trade on them but also in the flexibility of execution. During the initial CESR consultation around trading venue functionality, the Wholesale Market Brokers Association, worked actively to demonstrate to policy influencers the importance of discretion and flexibility in arranging liquidity across a variety of execution models in markets that tend to trade episodically.
OTFs as they stand in the recently proposed Mifir text appear to support this model with the EU proposing that OTFs not only have discretion over who they accept to trade but also, crucially, over how those trades are executing, leaving room for voice brokerage of deals as well as electronic trading.
Scott Fitzpatrick, client relations director at GFI Group says: “I think that the EU proposal is more true to the G20 mandate that trades should be transacted on electronic platforms where appropriate. In the US the CFTC are taking a rigidly prescriptive line currently mandating that cleared, non-block swaps trade electronically, despite the Dodd Frank Act stating that ‘any means of interstate commerce’ may be used, whereas Mifir rightly provides discretion to OTFs in this area.”
Indeed, this lack of opportunity for hybrid execution in the US has met with strong opposition from US brokers and other market participants. Daniel Marcus, strategy director at inter dealer broker Tradition, echoes the thoughts of many when he says that SEFs must have the ability to trade through voice as well as electronically.
“SEFs have been defined under Dodd-Frank as an intermediary that can arrange transactions between by any means of interstate commerce. To do this, they should have the freedom to determine how they execute trades in the best interests of their clients,” he says.
“It is widely accepted that, in contrast to what Gary Gensler seems to be saying, you cannot mandate all SEF products to be traded electronically. We don’t want prescriptive execution methodologies to be introduced that are destructive to the market and in times of market stress, you need the ability to pick up the phone a get a deal done.
“If you look at trade execution this summer, there was lots of electronic trading in July. In August and September, while the markets were volatile, brokers reverted to voice trading,” he says.
Fitzpatrick adds: “Hybrid mediation is integral to the operation of the OTC derivatives market. If you try putting it on screen you will severely impact liquidity in parts of the market.”
Request for quotes
Another issue that many take with the current CFTC proposals for SEFs is the requirement that they operate a Request for Quote model (RFQ), with five requests being sent out. The rule is intended to boost transparency but many in the market are worried about unintended consequences.
Not only does this potentially mean that you will have a divergence with SEC rules, which mandate the need for only one or more quotes to be put on screen, there are also concerns that a one-to-five RFQ could widen spreads.
Kevin McPartland, director of fixed income research at TABB Group, says that five is an arbitrary number and one that is not supported by historical precedent in this or any other financial market.
“Although we firmly believe a principles-based approach to SEF regulation, one in which they are free to compete with each other based solely on their merits is best, in keeping with the goals of Dodd-Frank changing the RFQ requirement to read “more than one” would act as a reasonable compromise that would not impact the majority of RFQ trades done today,” he says.
Fidessa’s Grob adds: “You have to be careful that liquidity does not start chasing itself. To try to orchestrate the detail is a dangerous thing, regulators risk creating unintended consequences that they will end up having to regulate on. It becomes a vicious circle.”
Others have raised issue with the technology requirements of the near real time data reporting for SEFs in Dodd-Frank and the apparent need for a complete overview of the market in order to monitor counterparties for OTFs set out in Mifir.
Under Dodd-Frank, the completion of a deal will have to be reported to a trade repository within 15 or 30 minutes depending on the nature of the transaction. Jeff Gooch, chief executive of MarkitSERV, says: “It will cost tens of millions of dollars to change the data reporting to 30 minutes. I think that this is unnecessarily quick. The EU time requirements are not as strict as Dodd-Frank and appear to be better thought out than Dodd-Frank in its current format.”
However, while trade reporting is not required in such real time under EU regulations, requirements that would force OTF operators to know the positions of all ultimate counterparties are causing concern.
GFI’s Fitzpatrick says: “There is the proposal within the Mifid text that platforms will be responsible for position management and limit setting in certain commodities and potentially for specific counterparties.
“Given that no single trading platform will neither know the counterparties’ risk positions nor have a complete view of all the transactions taking place on an intra-day basis, we will need some clarity as to how the regulators think this can be implemented at a technical level. A client could execute a trade on a competitors’ platform and 30 seconds later execute another trade on our platform, I’m not sure how our position management models are expected to deal with that.”
Regulatory arbitrage
All these issues pose a significant challenge to market participants preparing to establish themselves as SEF and OTF complaint as the regulations take shape. Derivatives trading is an international business and brokers and other wannabe SEF/OTF owners are faced with the task of designing platforms that are compliant in different jurisdictions.
Different providers appear to be taking on different strategies with some building the same platform with different checkboxes depending on jurisdictions and others running the same source code but providing different screens depending on the location.
Tom Rogers, community manager at Thomson Reuters, questions whether the entities will have to be physically moved into different jurisdictions and whether clients will have to be recontracted to trade on the platforms.
Thomson Reuters is building a single platform that will cater to both markets. Compliance for the different regulatory frameworks will be enabled through a global rule book that manages the different requirements of that jurisdiction.
“The key will be flexibility,” Rogers says. “We currently know a lot of the areas that will be mandated and are building them into a platform with flexibility. For example, if a product is mandated for clearing, there will be a box to check that will send the deal to a CCP, the same applies for trade reporting. “
On current reading, the rules proposed by the CFTC in the US certainly appear to be more restrictive than in Europe when it comes to the implementation of electronic trading for OTC derivative. However, Fitzpatrick says that is quite possible it will lead to some shift in business to European platforms.
“I don’t think there will be a wholesale exodus of product trading from the US markets offshore, however more prescriptive regulations could damage liquidity in US markets,” he says. “A lot of these products trade on a regional basis and they will continue to do so but you will see volumes being impacted if the trading environment is not conducive to doing business.”
Extraterritoriality and the interoperability between different jurisdictions is a key issue in light of the different regulations being proposed in the US and Europe. Under current proposals in the US, any entities that trade in US swaps, and US based entities could be subject to certain US regulations. The uncertainty surrounding this issue is causing much concern.
“One of the aspects of extraterritoriality we are monitoring is how it could impact firms like ours from an administration perspective. As an example, if we match a US entity against an Asian entity in a European product on a platform that is based in London, how and where will our platform have to be registered and what reporting obligations will we have based on the product, and/or counterparties,” Fitzpatrick asks.
“Will there be equivalence regimes implemented that will recognise an OTF as equivalent to a SEF from a compliance perspective or will our EU platforms need to be registered as a SEF or FBOT? There is still a lot to be understood on this particular area of the proposed structures.”
Banking on change
For all the changes that the introduction of SEFs and OTFs will bring to the market, it will be the dealer banks that are most affected by the new regulations. Current proposals in both the US and Europe appear to ban single dealer platforms for trading standardised swaps, forcing a radical shift in banks traditional business model.
McPartland of Tabb Group says: “If major dealers cannot create their own SEFs then their trade volumes will have nowhere else to go but through an independent SEF. Furthermore, with the behemoths of OTC derivatives locked out of the SEF picture, the inter-dealer brokers and independent platforms will be large and in charge.”
In general, banks currently trade in swaps bilaterally on behalf of their clients taking their cut from spreads. Rogers of Thomson Reuters says that banks will have to move from a business where revenues are based on spreads to a fee-based model.
“When it comes to standardised swaps, banks will no longer be risk managers. They will have to execute where the market is, there is no spread any more. This will have a massive impact on the market,” he predicts.
Currently around 15 banks control the lion’s share of the market. Banks have spent tens of millions of dollars on single dealer trading platforms that they will no longer be able to use for standardised products.
However, Rogers says that banks should not fear the transition. “It is a nice business model. Taking fees for trades and getting a clearer picture of the market through their clearing operations. The implications for smaller banks are worse though, the new market will be a big challenge for smaller banks.”
Writing in last month’s FOW, Kenan Maciel, the director of Lab49’s strategy group, said that banks could establish themselves as “SEF aggregators”, routing client orders to the appropriate SEF or OTF.
Grob says that this is a viable strategy: “A key issue for banks is where do they position themselves in the queue for order flow. They are either going to establish themselves as a super-SEF that will reach out to all the other SEFs or take a more passive position.
“The advantage of becoming a super-SEF is that they get the order from the client first and have to match it up. The disadvantage is that they will have to spend more money on technology and have commercial arrangements in place with all the other downstream destinations.”
Ready or not, SEFs and OTFs are coming. Whether their introduction will mark a permanent overhaul in how OTC contracts are traded or simply a fast track breeding ground for the development and testing of exchange traded products remains to be seen but, as regulators grapple with the finalisation of the rules, they would do well to listen to the concerns of the market to ensure that their new inventions can get off the ground.