Voice Brokers, FCMs & the Debate About When Execution Occurs
I am often asked what is the goal of Dodd-Frank? While there is no good, short answer, I usually reply “to prevent another financial market meltdown.” Dodd Frank aims to do this by moving transactions on to a central clearing house where margin is posted, counterparties are anonymous, and positions are “marked to market.”
At the heart of the 2008 financial market collapse was the fact that some trades were done based on counterparty credit: no monies posted, nothing more than faith that you will repay me when I ask you for my money. So when balances sheets eroded, counterparties became nervous with their complex web of credit exposures. They feared that withdrawing funds from one counterparty might destabilize another. All of this risk could not be easily undone or quantified and led to the freezing of the credit markets.
The federal bailouts unwound this complexity. Dodd-Frank created new laws to change the way the markets work, going forward. The Commodity Futures Trading Commission interprets that law, creates mandates, and handles enforcement. One such mandate is CFTC Rule 1.73, which requires executing firms to agree to screen customer orders for risk-limit checking purposes. This rule has been under intense focus at various tradeshows and conferences over the past six months as FCMs are growing increasingly nervous over the democratization of the OTC world and the amount of participants attempting to access it.
The futures commission merchants (FCMs) want voice brokers to perform pre-trade risk limit checks of their participants. Voice brokers counter they do not have the technological means or capacity to perform such checks in a voice-dominated marketplace. Brokers are also quick to point out that risk-limit checking is occurring, albeit post-trade, at the central clearing houses such as the CME and ICE, when the trade details are submitted though their respective websites.
Still, regulators are looking into the debate to define at what point does a trade precisely occur? In a pre-Dodd-Frank world, OTC transactions were conducted over the phone and were an art form rather than an exact science. Brokers would call traders asking for indications of interest in order to build a book of quotes they could then show to potential customers looking to consume liquidity. In this world, all quotes are indicative and displayed as “best efforts.” Traders are allowed to “back away” from their quotes, often blaming that too much time has passed or their opinion has changed. This eventually evolved into cat-and-mouse games between the brokers and traders, each probing each other with quotes in order to estimate at what price the other is likely to be firm.
The regulatory push to clear this OTC world and make it look more like a central limit order book has led to an interesting standoff among participants: those who are used to the way quoted markets behave versus those dealing with firm orders. In a voice-brokered market there is still some ambiguity about when the trade actually occurs, since a voice broker can technically tell both participants they are filled, but later that day the same broker can back out of that trade if, for example, it is rejected by the clearing houses for a risk limit breach. In contrast, a firm order sitting on a central limit order book is considered “available for immediate execution.”
The big difference is that orders sitting on the central limit order book have already gone through a risk limit checking process -- and those quoted by voice brokers have not. The question remains: Is that about to change? There is no doubt that voice brokerage firms have been under enormous pressure in an environment of declining volumes, exacerbated by extremely low interest rates and regulatory uncertainty. However, it is clear that the regulatory authorities have their sights set on pre-trade risk limit checking and expect all execution brokers to comply. In addition, the FCMs, who are the eventual holders of this risk, have made it clear to the regulators that they don’t want quotes occurring with voice brokers that are outside of risk parameters.
In the near future, brokers will need to move away from instant messaging and toward more robust technology that allows for pre-trade risk limits to be conducted, for an audit trail to be created and for straight through-processing of trades to the clearing houses.
Anthony Tassone is founder and CEO of Green Key Technologies, a provider of voice and trade capture solutions for the financial markets community Mr. Tassone is a software architect, former quantitative strategist and exchange executive holding patents in voice software and ... View Full Bio
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