Swaps Trading in a Post-MiFID II World - Lessons Learned from the U.S.

Enrico Bruni, managing director, head of Europe and Asia business at Tradeweb, compares swaps reform in Europe and the US, and highlights the risk of fragmentation in the absence of cross-border equivalence.

Right around the summer of 2013, just as the final rules for swap execution facilities (SEFs) were being entered into the Federal Register, many industry-watchers were forecasting the impending death of the U.S. swaps market. Critics warned that the new rules would cause everything from fragmentation of liquidity and low-latency arbitrage to an outright exodus of OTC derivatives trading from the U.S. 

In fact, the transition to mandatory electronic trading of swaps in the U.S. caused none of this. Quite the opposite. Immediately following the mandate, an August 2013 report from Aite Group showed that U.S. derivatives market participants absorbed Dodd-Frank trading requirements in stride, with cleared IRS and CDS trading volume surging in the weeks following new clearing mandates and the final SEF rules.  Now, over three years after the mandate was published, Clarus Financial Technology reports that the total volume of USD interest rate swaps trading taking place on SEF platforms is continuing to thrive, with over $1.3 trillion in notional trading in December 2016 alone.

With less than a year until MiFID II comes into force, bringing with it several similar regulatory hurdles for swaps market participants to overcome, many of the same fears are starting to emerge in Europe. Naturally, the U.S. experience has emerged as a benchmark for what to expect and how to prepare. While there are many similarities between the two reforms, there are also many details unique to each that could complicate things for firms that don’t take a rigorous, but flexible approach to MiFID II preparation.

Let’s start with the similarities. The big fear with both mandates is that these severe changes to the trading workflow – movement of trades onto electronic platforms, mandatory clearing, automated trade reporting – could adversely affect market structure. 

What U.S. market participants quickly found in the Dodd-Frank experience was that flexibility and efficiency were the keys to liquidity and profitability.  By moving IRS and CDS swaps trading onto electronic trading platforms, market participants are able to realise enormous gains in efficiency that offset the challenges presented by new trading requirements.  It is therefore critical that MiFID II preparations centre on trading efficiency as a primary goal. 

In order to achieve that ultra-efficient, integrated workflow, firms need to be able to connect internal risk, compliance, accounting, collateral and order management systems (OMS) with external trade execution and processing functions, such as clearinghouses. It also makes sense to work with firms who have been through this exercise and are familiar with the various technical and logistical challenges that can cripple the best-intentioned transitions to regulated, electronic trading.

When it comes to navigating the differences between the two regulations, one of the biggest issues market participants will need to contend with is the inherent fragmentation that will exist between the two sets of laws.  While regulators on both sides of the Atlantic have repeatedly stressed their intention to harmonise their rules to avoid this fragmentation, the very real potential exists for MiFID II to create distinct silos in the swaps market, with U.S. firms trading primarily with other U.S. firms and European firms trading primarily with other European firms, and so on around the globe.

In addition, fragmentation could lead to inefficiency and increased costs for market participants and end investors alike.  To maintain well-functioning global markets, regulators need to establish clear and workable cross-border rules using regulatory tools, such as substituted compliance, exemptive relief and equivalence. Following the financial crisis in 2008, regulatory reform has been driven by the same objectives of reducing systemic risk, increasing transparency, and improving market efficiency. Reaching an agreement should, therefore, be achievable and a desired outcome for all parties concerned.

However, with many of the details of cross-border equivalence still unknown, market participants need to be ready for a number of different potential outcomes.  Just as we saw with Dodd-Frank, as fears mounted that U.S. traders would simply pick up and move their operations to less restrictive regimes, the power of efficient, transparent trading on electronic platforms kept them engaged. Ultimately, we expect the same outcome with MiFID II, though to get there, trading firms will need to make sure their technology platforms are both flexible enough to incorporate incremental workflow changes and global in reach to allow for seamless trading between regimes that each play by slightly different sets of rules.

Originally published in FOW magazine.