Ready or Not, Here Comes the DTO
Q&A with Marcus Schüler, Managing Director and Head of Regulatory Affairs and Market Structure and Mike Thorpe, Managing Director and Head of European Sales at Tradeweb
The day of reckoning for MiFID II is just weeks away, yet there are still more questions than answers on many of the regulation’s finer points. Perhaps the most significant of these is the Derivatives Trading Obligation (DTO), which will move trading in certain liquid derivatives from over the counter (OTC) onto regulated trading venues.
That sounds simple enough, but the devil is in the details. Determining which derivatives fall under the obligation, defining which parties to a trade fulfill which roles of the new trading requirements, and figuring out how to treat the extraterritorial reach of the DTO are all still very much up for debate among market participants.
To help offer some insight on the key issues confronting the markets, Marcus Schüler, MD and Head of Regulatory Affairs and Market Structure, and Mike Thorpe, MD and Head of European Sales at Tradeweb, recently engaged in a discussion on the impact of the DTO on trading workflows, and the lessons learned from helping clients successfully navigate the US SEF transition. Following is a recap of that conversation.
Mike Thorpe: What are likely to be the biggest challenges faced by market participants?
Marcus Schüler: The DTO has been expected for a long time, but the final draft for the Regulatory Technical Standard (RTS) was published by ESMA only a few weeks ago, and the proposed go live date for Category 1 and Category 2 firms has been set as January 3, 2018. The question then is whether firms will be ready to trade on that date or will have sufficient time to onboard.
Thorpe: What are the key differences between the U.S. SEF requirements already in place and the European obligation set to go into effect in the beginning of 2018?
Schüler: There are three main points to consider. First, what will fall under this obligation and how it is being determined. The European obligation contains more flexibility, and what should be traded was decided differently. Look at the Made-Available-to-Trade (MAT) process in the U.S, where the venues would determine what’s traded on SEFs. It’s different in Europe, where the process to determine which products are sufficiently liquid to be traded on venues has been driven by ESMA.
Second, the scope of each obligation is more limited in Europe. This is at least partially based on the fact that some of the data wasn’t available to ESMA at the time it was making its determinations. That might change once the MiFIR reporting regime is in place.
Third, more flexibility in the use of trading protocols is available in Europe for when a firm satisfies the trading requirement and wants to trade on an OTF or MTF or a RM. Conversely, the CFTC adopted a more restrictive approach by determining how a SEF operates, and what kind of protocols it needs to make available.
Schüler: What can we learn from the U.S. experience and is this good guidance as far as what we might expect for Europe?
Thorpe: The most obvious takeaway is that the volume of derivatives traded electronically will increase. Look at what happened because of the SEF requirement under Dodd-Frank. The DTO drove a ten-fold increase in dollar swap activity on Tradeweb during the first six months. More importantly, less than 10% of dollar swap volume was executed electronically in 2013. This has now surged to 50%, while 75% of volume in CDS indices is now traded on SEFs. We’d expect to see something similar after January 3 in Europe, although we are starting from a higher base here.
Next, some other MiFID II requirements, such as reporting or order record keeping, might drive a greater migration for OTC derivatives towards trading on trading venues.
Also, electronic trading became contagious once introduced to the buy side. It has increased efficiency and offered more competitive pricing from a wider liquidity pool. In fact, over 45% of on-SEF volume is in instruments that are not required to trade on SEFs, and that includes sharply growing volumes in Euro and Sterling swaps.
Thorpe: Do you expect European and U.S. regulators to make regulatory harmonization and equivalence a priority ahead of January?
Schüler: Those are two different questions. Looking at the scope of the obligation, we’ve already seen significant harmonization across products, and this is a positive. Now, there’s concern that if the rules come into effect and there isn’t any equivalence, there could be fragmentation of liquidity. This is on the minds of both those in the market and regulators. But based on what we are hearing from the European Commission and the CFTC, there’s confidence that equivalence can be reached in time.
Schüler: How about the clients’ perspective? How would you describe their level of preparedness for the DTO in Europe, and are there differences among the different types of clients?
Thorpe: Many of the larger, global clients have been clearing and trading derivatives on SEF electronically since 2014, and this acted as a catalyst for greater acceptance of this type of trading for these types of institutions. Many European investors have been migrating to cleared derivatives well ahead of their EMIR requirement. Those that have funds split between Category 2 and Category 3 have been moving to clear voluntarily for their Cat 3 funds, so they can trade in a unified manner. Even pension funds and asset managers that aren’t likely to be required to clear under the DTO in the foreseeable future are doing so voluntarily. This is potentially an indication that it’s easier to access liquidity in a cleared world, and harder to do so for uncleared, bilateral trades.
Thorpe: Let’s talk about market structure for a moment. How does ESMA approach block trades, and what is the relevance of pre-arranged trades in the context of the DTO?
Schüler: As with package trades, ESMA took a slightly different approach than the CFTC did in the U.S. Whereas the CFTC rules explicitly allow for block trades over a certain amount to be transacted off venue, ESMA said such approach wasn’t necessary in Europe given that waivers and deferrals under MiFID II / MiFIR already provide sufficient protections for larger transactions. That, combined with flexible protocols, would allow for market participants to be protected from information leakage while still executing larger trades on-venue.
Thorpe: What about package trades? How are these treated in the derivatives trading obligation?
Schüler: This is one of the more controversial topics, and something that has yet to be fully addressed. In its consultation paper, ESMA included a discussion on the treatment of such packages and stated that it didn’t have a mandate to create a specific regime for them. It also noted that the so-called no action relief issued by the CFTC had run out. ESMA concluded that if one leg of a package trade was subject to the trading obligation, there would be no exemption for the package.
But this is still somewhat unresolved. ESMA stated it might attempt to clarify its intentions with regard to package trades, but it didn’t specify what parts of the rules it would discuss.
Tradeweb already supports contingent packages of both IRS and CDS specified in the DTO (e.g. curves and butterflies of benchmark swaps), and we’ve started moving towards other types, such as asset swaps of government bond yields and invoice spreads (e.g. swaps vs. futures). As we further build out the functionality, we expect to see more dealers and more of these types of contingent packages on the platform.
Schüler: Let’s go back to those workflows. Describe what makes them so complex and what challenges a firm that isn’t already trading electronically might face.
Thorpe: Managing workflows in the context of the DTO presents a major challenge to clients. Multiple counterparties are trading with one another across different clearinghouses sometimes between the U.S. and Europe, and this is before one considers the underlying nature of the clients and whether they are trading IRS or CDS. So if a firm hasn’t already been preparing for the January 3 start date, it’s unlikely to be ready to go on that day.
Then there’s the tech element. There are plenty of different parts of the DTO driving derivatives trading electronic, but they aren’t all yet complete. Neither is connectivity. This may be a blocker for some firms.
There’s also likely to be an onboarding rush as the start date of the obligation approaches, and clients feel the heat trying to get ready.
But this shouldn’t discourage firms from beginning the process to become more electronic. Tradeweb helped U.S. clients successfully navigate the SEF obligation, and we already have a wide range of tools in place to help European clients make the transition both seamlessly and efficiently.