Derivatives markets are being simultaneously reshaped by two forces. On one side, MiFID's long-planned extension into derivatives has been given additional impetus by a global regulatory agenda that aims to reduce systemic risk, especially in the over-the-counter derivatives space. On the other side, technology is empowering new liquidity venues and faster trading styles and providing new tools to navigate the resultant big data swamp. The opportunity for market participants is to understand how they can step through these changes and create sustainable competitive advantage. The alternative is to simply comply with the rules. But this means committing to a never-ending game of catch-up that just adds cost to an already strained business model.
This state of affairs shows little sign of abating. MiFID II, European Market Infrastructure Regulation (EMIR) and Dodd-Frank are still to take final form and, if the experience of equities markets is anything to go by, we will face an inevitable slew of unintended consequences.
From OTC to OTFs and SEFs
The imminent regulatory changes will reach across the entire derivatives food chain, but venues are likely to feel the impact first and hardest, especially in terms of where and how derivatives contracts are traded. The shifting of bilateral OTC activity onto centrally cleared, electronic platforms -- Organized Trading Facilities (OTFs) in Europe and Swap Execution Facilities (SEFs) in the U.S. -- is perhaps the most obvious example.
Despite the enormity of this project and the aggressive implementation timeline (2013), much remains unclear. What is certain, however, is that politicians and regulators are unwavering in their belief that centralized clearing reduces systemic risk. As a result, this is a central pillar of both EMIR and Dodd-Frank.
This model has its critics, though. Some large buy-side firms see centralized clearing as potentially riskier than the OTC model, as their margins get mixed up with those of other firms that may or may not be equally creditworthy. In addition, central counterparty (CCP) clearinghouses generally do not hold a banking license, so they inherit credit risk from whichever bank or custodian with which they deposit their collateral. And there is an even more-fundamental question over whether the additional margin collateral demanded from the buy side will prompt some to avoid using derivatives altogether.
Pushing "odd-shaped" OTC contracts onto electronic platforms will be challenging, too. Both EMIR and Dodd-Frank recognize this, and both include the wording, "provided there is sufficient liquidity," in their requirements. "Sufficient" in this context, however, is difficult to define, as nobody knows how many platforms there will be or how (if at all) they will interoperate.
There also is concern over the impact multiple venues will have on average trade size. The experience from equities indicates that this concern is not misplaced. The introduction of competition by MiFID served to spread liquidity over multiple venues, and this inadvertently created the ideal operating conditions for high-frequency trading (HFT). HFT firms were able to take advantage of the maker-taker pricing models that emerged and exploit the tiny price differentials that appeared in the newly fragmented liquidity. The resultant inability to trade in size has been a consistent grumble from the buy side in post-MiFID Europe, and similar concerns now exist about the impact of OTFs and SEFs on derivatives markets.
In Europe, a number of entities, such as broker crossing networks and interdealer broking systems, are seeking OTF status, but regulatory uncertainty and a growing sense of "first-mover disadvantage" mean that completely new platforms have been slow to emerge. While the notional value of outstanding OTC derivatives is huge, the actual number of daily transactions is small and probably lends itself more to a request-for-quote (RFQ) model than a traditional order-driven market. This concern over liquidity has prompted some participants to see smart aggregation and routing among those SEFs and OTFs that do exist as the real prize. So, just as with equities, market participants will use technology to step in front of each other in their quest to obtain prime position in the queue for order flow.
In exchange-traded derivatives (ETDs), competition historically has been limited, a point that regulators used against the proposed merger of NYSE Euronext and Deutsche Borse. The big venues either own the intellectual property of their benchmark index products or control the open interest in their listed products through vertically integrated clearinghouses. As a result, competitor platforms are unable to draw open interest away from the incumbents. The vertical clearing model runs counter to the aims of MiFID, however, so the regulatory momentum is geared around horizontal or interoperable clearing.
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In anticipation of this, the race is on to buy or establish new indices upon which to base new derivatives contracts. Other venues, such as Nasdaq OMX's new NLX platform, are attempting to reformulate existing products and compete on cost either directly or through better margin offsets. Either way, the pattern of liquidity in ETDs looks set to become increasingly complicated as we see a number of attempts to create new instruments that aim to be economically identical to those of the incumbent exchanges. Whatever happens, market participants will face some tough decisions about which initiatives to support, either in terms of providing liquidity or participating more directly in their construction.