E-Trading of OTC Derivatives: The Impossible Just Became Possible

| FinReg

By Rebecca Healey, TABB Group

Originally published on TABB Forum 

The electronification of the over-the-counter derivatives market is happening much more quickly than anyone would have guessed. And it is driving a shift from the use of equity derivatives primarily for hedging to their use in the pursuit of alpha.

“OTC derivatives trading electronically? Never gonna happen.” A trader told me this only a couple of months ago. He may just want to eat his words.

In fact, the speed at which the supposedly sacred OTC derivatives markets will succumb to the vagaries of automated trading will happen at a far greater rate than most of the market suspects. New requirements for improved trade reporting will spearhead widespread uptake of automated workflows, transforming the equity derivatives market in the process.

EMIR Has Landed                                                      

EMIR technical standards on OTC derivatives regulation 648/2012 will require all counterparties to comply with operational risk management requirements – including timely confirmation, valuation, reconciliation, compression and dispute resolution – by mid-2013. The automation of workflows not only will enable firms to meet regulatory requirements, it will open up new opportunities to hedge risk, calculate margin and source liquidity, as increased use of data and technology will ensure the transition from a largely OTC bilateral market to electronic trading.

Meanwhile, as the need for trade certainty takes center stage, the introduction of the STP process will become the catalyst for the explosion of automated trading.

Turquoise, part of the LSE Group, announced this week that it will introduce trading in single-stock options, initially offering reporting of trades in single-stock options for 19 UK mining and energy listed companies. The introduction of trade reporting for UK options on June 10 will allow investors who already trade single-stock options and futures on other LSE-operated platforms to net their positions at LCH Clearnet.

From Hedging to Trading

Historically, European equity options have failed to reach the level of US interest; and interest from market participants remained centered on using options for hedging purposes rather than as a trade in its own right. However, the reasons for trading equity derivatives are already shifting as the cost of the insurance is becoming larger than the payout. Depleted margins and bank deleveraging due to Basel III are increasing the cost of hedging in the traditional sense. There is now little appetite for market makers to offer to warehouse risk for anyone other than the most lucrative clients. Increasing initial margin requirements plus onerous capital charges are removing the incentive to trade a large swath of non-clearable “exotic” derivatives. As a result, clients are being forced to standardize their product usage.

Investors are diversifying away from cash equity holdings at the same time as the derivatives product spectrum is becoming increasingly vanilla. This influx of new participants is transitioning the use of equity derivatives from a predominantly hedging function to a trading opportunity and altering the structural makeup of the market in the process.

Systemic Risk to Liquidity Risk

Similar to the changes in cash equities markets, traditional market makers will be forced to exit as automated trading gradually encroaches on their market share. Market participants will resort to greater levels of technology in order to transact their trades. Automated trade flows will lead to average trade sizes shrinking to avoid market impact, creating an increased feedback loop attracting further diversity of market participants and creating challenges for bilateral phone trading, hastening its demise.

While the move from a labor-intensive voice process to a centralized, transparent pricing module appears to be a slam dunk requirement for the buy side, the increased level of transparency will morph systemic risk into liquidity risk. The obligation to hold more collateral for OTC transactions will create additional pressure to hold liquid-only assets. As participants fight for dwindling liquidity in a reduced number of names, the liquidity premium will increase, and less actively traded instruments will become increasingly scarce.

Breaking down silos and resolving inefficient usage of collateral will now become a priority for firms obligated to hold more collateral for OTC transactions. Without an automated workflow process, efficient management of collateral will be impossible to manage. Without an optimal way to analyze the availability of collateral, there will be no way to ensure the ability to trade.

The ability to harness any available liquidity across the widest spectrum of instruments will require increased use of technology, irrespective of whether this is via a central limit order book, auction or RFQ process. The automation of the workflow process will make the step from partial to full automation merely a hair’s breadth away.

Technology is set to become the essential lifeline. As the evolution of OTC derivatives trading will transform the market from a predominantly voice-brokered industry to an electronic STP model, trading European derivatives successfully will become increasingly dependent on a combination of low-latency trading, global fund flows, data, trade analysis and, ultimately, economies of scale. The impossible has just become possible.

Tags: FinReg, Blog , Regulation