Mandatory Electronic Exchange: Determining the Right Market Model for OTC Derivatives

Emergence of Regulation



In contrast to the consensus achieved with reporting and clearing, the emphasis the G20 placed on “where appropriate” in its directive invited many jurisdictions to carefully assess the need and impact of implementing electronic execution. The Financial Stability Board (FSB), an international body charged with driving standards for the G20, highlighted this point on June 15 in their third progress report on implementation of OTC Market Reforms. In the report, they requested regulatory authorities from around the world to take action and investigate the benefits and costs of public price and volume transparency. The FSB also encouraged exploration of the potential impacts on wider market efficiency, concentration, competition and liquidity. At this time there is a clear divergence among regulators.
 
The European Securities and Markets Authority (ESMA) in Europe is looking to implement an electronic execution mandate through Markets in Financial Instruments Directive (MiFID) and Markets in Financial Instruments Regulation (MiFIR). Their Multilateral Trading Facility (MTF) and Organized Trading Facility (OTF) model is likely to be enforced in 2014.

The CFTC in the US is further ahead, although, at date of publication, the final rules for Swap Execution Facilities (SEFs) have not been published and timelines for enforcement are unclear and are now likely to be later in 2013. 
 
While not officially part of the G20, the Monetary Authority of Singapore (MAS) and the Hong Kong Monetary Authority (HKMA) have adopted a selection of G20 commitments, specifically the clearing and reporting regimes. However, due to the size and relative illiquidity of these region’s OTC derivative markets, they have decided against implementing rules for mandatory trading on regulated platforms. Asian regulators recognize that, compared to the US and Europe, the products traded locally are considered to have low volume resulting in illiquid market that is unsuitable for an exchange trading mandate. 


[Buy Side Needs to Assess Readiness for Derivatives Regs]

As a result of jurisdictionally divided market practices, one concern that has been raised a number of times in relation to US and EU-centered institutions is the possible loss of business for highly structured trades and the high risk of liquidity fragmentation. Highly liquid markets could become less so because dealers are forced out by excessive regulation into less liquid markets. This could result in decreasing suitability for electronic execution in the formally highly liquid markets and encourage firms towards less regulated regions and markets.



Potential Impact



The potential impact to the market is amplified when considering the “multiplicity effect” of introducing multiple regulations in parallel and the perceived reaction from end users that derivatives, which are now subject to additional capital and transaction costs, might become prohibitively expensive resulting in a decrease in trading volumes. Therefore, any mandated electronic execution must consider and factor in the potential of markets becoming less active and the potential need for guidance on scenarios where exemptions might be appropriate due to a lack of liquidity.
 
 


Conclusion



There is a valid concern that the introduction of an electronic execution mandate could harm the OTC derivatives market by forcing complex derivatives to be traded in the same way as highly liquid products where the practice is not suitable. The very purpose of complex exotic OTC instruments is that the specific terms and dates can be tailored to suit the parties involved and defer the risk from those who are willing to pay. These products are so non-homogenous there is a reason why they have not been traded on exchanges up to now. In contrast, electronic execution for products with the necessary liquidity and maturity has the potential of achieving genuine cost and operational efficiencies. The question remains whether there is a need for regulation to achieve that goal and whether regulatory overreach could, in fact, damage the markets they are being introduced to protect.
 


Ryan Baccus is a VP based in London leading the Market Infrastructure and Initiatives Practice, with nine years of OTC derivatives experience.


Paul Gibson is a Senior Associate based in London working in the Market Infrastructure and Initiatives Practice, specializing in capital market initiatives.

Jon Szehofner is a Manager based in London, and is one of Sapient’s lead consultants within the Risk Assurance Practice, where he specializes in regulatory reporting.

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