Mandatory Electronic Exchange: Determining the Right Market Model for OTC Derivatives
In response to the G20 declaration, nations around the world have begun working towards developing consistent regulations for the global OTC derivatives market and are in varying stages of implementation. Since the industry has been driving towards many of these objectives for years, there is a considerable level of consistency between regulations. However, when it comes to the directive of utilizing electronic trading platforms, many market participants have voiced concerns about its impact, particularly because it requires changes to the structure of trading in the OTC market and could potentially lead to increased cost of execution for participants. In this article, senior consultants at Sapient Global examine industry participant opinion on electronic execution, explore the perceived impact on an organization’s business model and finally discuss how the divided opinion has shaped an uneven regulatory landscape across the globe.
In the wake of the financial crisis, the G20 leaders laid out the path to reforming the Over-the-Counter (OTC) derivatives market by committing to four key objectives:
1. All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate
2. All standardized OTC derivative contracts should be cleared through central counterparties by end-2012 at the latest .
3. All standardized OTC derivative contracts should be reported to trade repositories
4. Non standardized/centrally cleared contracts subject to higher capital requirements
The G20 declaration on market regulation has led to broadly consistent implementation across regions on three of these directives. Market participants are generally supportive of efforts to increase central clearing of trades and to improve post-trade transparency. These initiatives were developed to build a stronger financial system and reduce systemic risk. The electronic execution element is more contentious because the proposed changes will affect the structure of the OTC derivatives market and there is divided opinion among participants as to whether this will actually achieve the goal of post-crisis public policy initiatives.
Gary Gensler at the Commodities Futures Trading Commission (CFTC) has been particularly vocal in arguing the benefits of all buyers and sellers operating within a transparent marketplace. The CTFC points to benefits, such as more resilient liquidity, better information for valuation and reductions in trading costs. The underlying belief at the CFTC is that the centralization of trading activity gives extra incentives for new participants to join and enhances competition. Many of the larger “G15” banks agree that moving some swaps from low-tech, high-touch, bi-lateral voice transactions to multiple trading venues may have a positive impact on trading for some types of organizations in highly liquid products. These same banks, however, object to a broad enforcement that captures all OTC trades in the same way.
With the OTC market characterized by low volumes, many industry participants believe that forcing bespoke derivatives to trade in the same way as listed products will make the costs of transactions unsustainable. As a point of reference on market activity, there are approximately 6,400 CDS traded in total worldwide daily (according to ISDA) and the LSE UK Equities order book is approximately 685,000 per day. Unless the product is highly standardized, electronic execution platforms could negatively impact liquidity and create uncertainty around the transaction. ISDA estimates that it will also increase transaction costs with the added expense of running a platform potentially exceeding $750 million and annual costs reaching as much as $250 million for the market.
The majority of market participants believe eligibility for electronic execution should also differ according to the nature of a given trading model. Listed products with competitive pricing are likely to have deep liquidity. Therefore, a central limit order book (CLOB) model, which allows for completely transparent bids and offers, is suitable. However, for many traditional OTC products that are more bespoke in nature and highly structured, a standardized CLOB model would not work because there is no standardization in either execution or the associated infrastructure. With traditional OTC products, a “request for quote” model is likely to be the only model that would work and, according to ISDA, a regulatory requirement to do otherwise would render them worthless and shrink the market.
As a result of the impending electronic execution mandate, a number of service providers are actively developing their platforms and expanding their client bases to ensure that they are positioned to capitalize on the demand for services from electronic trading venues. With the implied risk of trading activity being distributed across Swap Execution Facilities (SEFs), Organized Trading Facilities (OTFs) and exchanges, many in the dealer community are looking at ways in which they can aggregate the liquidity at these venues for their clients as a value-added service (known commonly as SEF aggregators)—assuming the regulation provides for the appropriate trading models to enable this offering. From a buy-side perspective, the commonly held view is that they would be in favor of electronic execution because it will drive down their transaction costs. However, along with the dealers, the buy-side community has voiced fears that the pre-trade transparency, which certain types of electronic execution enforce, will harm liquidity.
Many people agree with this view, including Barney Frank, of Dodd Frank fame, who clarified recently that the regulation was not designed to stop the practice of voice brokerage, and that five requests for quote before execution should not be the industry standard. This relieved many in the industry as they have long argued that if buy-side firms are forced to ask at least five dealers for a quote on a swap, information about trading intentions and trades will be more widely dispersed. This will create a situation whereby a dealer winning the trade from the asset manager may find it harder to hedge that position, as other rivals will be aware of the transaction. That increases the risk of portfolios being incorrectly hedged for abrupt swings in interest rates and other asset classes as investors seek cheaper alternatives to the OTC swap market.