One of the mandates of the 2009 G20 summit was to ensure the electronic trading and central clearing of standardised OTC derivatives. OTC or ‘over-the-counter’ is seen as the antonym to exchange-traded or ‘listed’ in most literature. Now, global regulators seem intent on removing OTC from the trading landscape.
Shifting bilateral OTC activity onto electronic platforms – organised trading facilities (OTFs) in Europe and swap execution facilities (SEFs) in the US – is the way regulators plan to achieve this paradigm shift. It is expected that a final rule on SEFs will be published soon by the Commodity Futures Trading Commission (CFTC) to see electronic trading of standardised derivatives become a reality in the first half of 2013. Interestingly though, the corresponding regulation in Europe is not part of EMIR but of the overhaul of the Markets in Financial Instruments Directive (MiFID II), which is not due to enter into force before 2015.
Despite regulators’ demand for new trading venues there are also sceptical voices in the market, which discuss the death of SEFs before they have even started. Tabb Group’s Adam Sussmann points out that a staggering 29 firms have announced their intention to become a SEF but he sees designated contract markets (DCMs) as better positioned as they can trade swaps next to a host of other instruments whereas SEFs can only trade swaps.
Where does this leave the market participants who need to adhere to upcoming regulations?
Only a small number of trading venues will actually become serious contenders in the market. These venues will largely comprise of current incumbents like ICE, Tradeweb or Bloomberg with only a very small number of new entrants uniting sufficient liquidity on their respective platforms. Liquidity is key in a market which is large in terms of outstanding notional but where the actual number of trades is rather low when compared to the equity markets.
The firms that are actually required to trade on such SEFs or OTFs face the daunting task of deciding on a platform. That the respective regulation in Europe lags at least 18 months behind makes it especially difficult for global market players. Smaller firms, like hedge funds, will neither have the time nor the resources to connect to each relevant SEF.
At this juncture prime brokers see a chance to change their business model of offering a single dealer platform to becoming an aggregator of SEFs. In addition, the experience of the equities market in recent years has shown that the proliferation of trading venues can lead to reduced trade sizes and the rise of arbitraging High Frequency Trading (HFT) as well as the creation of dark pools.
The current regulatory uncertainty leaves market participants struggling to plan their next move. Nonetheless, chance favours the prepared mind, so follow the regulatory processes closely to understand which possible trading venues are best suited for your business model.
Next week I’ll shine a light on proposed risk mitigation options for non-cleared OTC derivatives.
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