Mandatory electronic execution - what's happening around the world?
Following the financial crisis in 2008, legislators and regulators around the world focused on reforming the over-the-counter derivatives industry to reduce systemic risk, increase transparency, and improve market efficiency. In September 2009, the participants of the G20 Pittsburgh Summit had agreed that "all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties”. In response, many jurisdictions have, or are putting in place, electronic trading mandates for over-the-counter derivatives.
While the policy intent of regulators is very similar - to make markets safer and more transparent – the specific details being implemented are often very different. In Japan, for example, the rules are fairly self-contained, only applying to the largest Japanese banks trading with each other, while the U.S. rules apply to any swaps transaction where at least one party is designated as a U.S. Person.
The new or upcoming regulatory regimes for the trading of derivatives have already significantly changed the global swaps industry, particularly in the U.S., where the Commodity Futures Trading Commission’s rules are now almost fully in place. In other countries, many participants are already preparing for impending new requirements.
These rules are engendering some of the most significant changes to derivative market structure for some time, and the U.S. experience can offer some useful lessons for other regions. Trading platforms have also been implementing a range of innovative products and services to improve trading efficiency within the derivatives markets.
The United States introduced the Dodd-Frank Act to regulate the OTC derivatives market and meet the G20 commitment. The CFTC was primarily responsible for writing the rules under which the swaps industry would need to operate. Their requirements cover transactions by or with firms that are U.S. Persons, and mean that all interest rate and credit default swaps that have been certified as “made available to trade” must now be traded on swap execution facilities or designated contract markets. Certain aspects of the trading mandate, such as package trades, were phased in, which helped market participants to adapt more easily to the changes.
The rules are relatively prescriptive in certain areas. For example, SEFs must offer an order book and can also provide a request-for-quote system, price takers must request quotes from at least three dealers in an RFQ, pre-trade credit checks must be performed, and there are specific requirements around block trades. These rules have given rise to new functionalities to help market participants meet these obligations while also enhancing the efficiency of the trading workflow.
One example of this has been the introduction of compression trading. The requirement to clear derivatives trades resulted in the need for institutional investors to manage effectively their line items at the clearinghouse, as each outstanding transaction increases costs and capital. Netting or terminating line items has typically been a highly manual process, but electronic venues can offer an efficient mechanism for executing offsetting swap trades to eliminate these transactions. This functionality has proved to be particularly useful to derivatives users, and more than $1.2 trillion of notional compression volume has been executed on Tradeweb since November 2013.
Although electronic trading of interest rate swaps has been possible for several years, it was estimated that less than 10% of dealer-to-customer volume in the U.S. was transacted electronically before SEFs were launched. The transition towards e-trading occurred at a much faster rate only after it was mandated - on-SEF U.S. dollar swap volume now stands at more than 50% of the market.
In Europe and Asia, the benefits of these types of electronic solutions are already being realised, even before e-trading becomes mandatory.
The pieces of legislation underpinning trading reform in Europe are the Markets in Financial Instruments Directive II and Regulation, which jointly replace, and significantly expand, the original MiFID. These laws are broad in scope, as they apply to financial instruments that weren’t covered in MiFID I (which mainly applied to equities), including bonds, derivatives and ETFs.
The derivatives trading obligation as outlined by the G20 commitments is covered by MiFIR, which also outlines requirements for pre- and post-trade transparency, trading venues, non-discriminatory access to central counterparties, and more. The European Commission elected to use the regulation (rather than directive) format, ensuring that the rules will be uniformly applied within the European Union. These requirements are generally principles based, aiming, for example, to achieve greater pre-trade transparency by “making information public”.
The European rules will require that all standardised, sufficiently liquid swaps trades be executed on regulated trading venues, which include multilateral trading facilities and a new category of organised trading facilities. The scope of instruments that will be covered under the rules will be determined by the European Securities and Markets Authority, which is also responsible for writing the technical standards that will define the implementation of the specific detail of the trading requirements contained in MiFIR. The submission of ESMA’s final regulatory technical standards to the European Commission is now expected in September 2015.
There are three tests that ESMA looks at when determining the scope of instruments that should be subject to the mandatory trading obligation:
- the EMIR clearing obligation applies, and
- the instrument is already traded on at least one venue, and
- it’s deemed liquid by ESMA.
There is also a separate liquidity test that will determine whether an instrument is subject to pre- and post-trade transparency rules. Therefore, derivatives that are not cleared or subject to the mandatory trading requirement may still need to meet the transparency obligations.
One area of concern within the MiFIR rules relates to the ESMA proposal that bids, offers and depth of market for certain trades must be published by RFQ-based venues, with the aim of increasing pre-trade transparency. While this is an important objective, the interpretation of the publication requirement could adversely affect the functioning of derivatives markets. If individual quotes are made public immediately, marketmakers could delay sending a price until they can see how others are quoting, and the public information that a trade is likely to occur could result in adverse market movements. This could reduce the competitiveness of prices and increase the risk of the trade. These are outcomes that would be detrimental to the price taking investor.
It’s important that the market has access to a range of protocols to suit the various needs of users and different liquidity profile of instruments. RFQ is the predominant electronic trading protocol so it is important to get this right. This could be achieved by allowing venues to publish dynamic pre-trade composites of trading interests, or to make prices public only once specified conditions are met or immediately after the trade is executed.
There is clearly still some fine tuning of the rules needed, and although it seems that the date that MiFIR will apply – January 2017 – is a long way off, its scope is very comprehensive. There is, as a consequence, a lot for the industry to do before then. A phased implementation would help participants get ready for the changes, while making sure there are no detrimental effects to the way the market functions.
Regulators in Asia are starting to provide more clarity around trading regulations for derivatives. Already, many institutions have been preparing for the new rules by increasing their use of electronic venues to execute swaps transactions. In Japan, for example, the first electronically-traded and JSCC-cleared yen swap transaction by a Japanese bank was executed back in June 2014, more than a year before the trading mandate in Japan will come into force on September 1, 2015.
The trading rules in Japan have been established by the Financial Services Agency and outline the requirements for a new “electronic trading platform” designation for electronically trading yen swaps. The rules apply to the largest Japanese banks in trades they make with each other that are executed within Japan.
Australia is also developing proposals for an e-trading mandate, while Hong Kong and Singapore are currently focused on implementing clearing and reporting requirements. While the Monetary Authority of Singapore has decided not to introduce a mandatory trading regime for now, it has left open the possibility of doing so in the future.
Technology helps the industry adapt
The use of technology makes it easier for firms to meet the requirements of existing and upcoming trading regulations, but electronic execution also offers many additional benefits. Greater trading and post-trade processing efficiency, alongside the reduction of costs and operational risk, have all been factors driving the market’s interest in electronic swaps trading.
As market structure and client behaviour keep evolving, execution venues that use their insight, experience and expertise to develop innovative trading solutions will continue to help market participants effectively address future regulatory changes.
Originally published in The OTC Space