The Odds of Exchange Migration
One of my more recent commentaries ("OTC, Central Clearing or Exchange-Traded: Choosing the Right Path") discussed the migration of OTC products from bilateral to centrally cleared to exchange-traded through changing reserve requirements. The logic went: Adjusting reserves changes a product's economics, which applies pressure on dealers to migrate away from bilateral clearing toward central clearing or exchange-traded, depending upon the punitive nature of the capital charge.
This commentary was a warning that just mandating a move toward central clearing or exchange trading without both changing the nature of the products and the incentives would not work. The markets are too complex, fluid and profitable for anyone to mandate how products trade. A mandate would only either force dealers to discontinue supporting the mandated products or provide impetus to shift the structures to one not included by the mandate.
While many believe that the migration of financial products to an exchange is the epitome of a free and fair market and all products should be traded on exchange, I am not sure that is true. What does the exchange bring? Transparency, regulation, and oversight. While regulation and oversight post-credit crisis may be welcome, transparency is a two-sided sword.
Transparency is not all that it's cracked up to be. Everyone wants transparency until they trade. Granted, transparency is great for small orders with no information content. However, once an order becomes impactful (which is defined by the market), transparency often adversely impacts execution. For example, when trading 100 shares of stock, information content and market impact is minimal; when trading 300% of the average daily volume, on the other hand, complete transparency will absolutely impact price (and not for the better).
With OTC products the contract sizes are usually large (in the millions of dollars), the products complex, and there are a limited number of liquidity providers. Putting many OTC products onto a transparent exchange, as products are today, I believe, would be a colossal failure -- independent of incentive. Currently the OTC markets are very dependent upon top banks to provide liquidity. If their or their clients' instructions were posted, mispriced orders would get picked off and large orders would get manipulated. Dealers would back away, spreads would widen, and investors would pay much more to get filled. In addition many dealers would stop providing support and pull out of the market, and liquidity would become even more sparse than it is today.
Migrating OTC products to exchanges cannot be mandated. Migrating OTC products onto exchanges requires a new product be created and supported by a new ecosystem. Look at exchange-traded products versus OTC products: Exchange-traded products are usually simpler, are denominated in smaller sizes, have a wider array of liquidity providers and have industrywide mandated risk mitigation processes. OTC products are typically large, complex and illiquid, and the organizations that market them usually manage risk independently.
To migrate a product from OTC to exchange (besides needing customers' demand), contracts need to be simplified and standardized, they need to be much smaller, risk needs to be defused and managed collectively, and to a certain extent you may need a whole new set of liquidity providers that are not tied to the old way of doing business. Standard contracts/products allow investors, liquidity providers and risk managers to better understand and offset risks. Smaller contracts allow new and smaller entrants to become liquidity providers, as how many non-mega-banks can risk millions of dollars on each and every trade without running out of capital? And of course, with more liquidity providers, a central clearing mechanism will be needed to ensure outstanding trades can be fulfilled even if market participants become troubled.
Do I think this is possible? Yes, it is possible, but not highly probable. Migrating OTC products to an exchange is a major challenge. Just shifting liquidity of an existing product from one exchange to another is challenging enough -- creating a whole new market, with new products, new liquidity, providers and new clearing mechanisms, without demonstrated customer demand? I just don't know that I would take those odds. However, given the market, the regulatory climate and dealer capitalization -- the odds of migration may never get better.
Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio
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