The WMBA’s Alex McDonald discusses how aggregated reporting of trades executed via trading facilities and interdealer brokers can provide the information on key market risk factors and trade activity required to allow for greater market supervision and transparency
Outside of the The Depository Trust & Clearing Corporation (DTCC) there are few other trade repositories of the type envisioned for OTC derivatives, and none have the systemic risk warning functionality that has been envisaged. Trade reporting to regulators is however ubiquitous. The main problems therefore, relate to the need to duplicate or triplicate this reporting of such eligible trades in the hope of categorising and factor modelling them into neat buckets of risk information that regional risk boards, or national supervisors may more simply interpret to provide into net and gross risk maps.
Whilst this would represent a fairly costly project for end users to fund [given that costs always get passed on]; it would be hard to envisage the large pools of capital surpluses in the world; – rich sovereign wealth funds and pools of money from investors and institutions – voluntarily allowing their positions to be held by technocratic authorities on the other side of the planet who perhaps don’t really have their best interests at heart.
Increased market integrity comes from advocating better market supervision, not from additional costly and non-global layers of new regulations. Enhancing market transparency without either decreasing the utility or increasing the costs to end users would be helpful so long as the confidentiality of risk positions or the propensity of banks to carry out their functions of lending, intermediating or performing risk transformations do not become compromised. One such tool would the aggregated reporting of market trades executed through the Interdealer Brokers (IDB’s) either as voice-hybrid trades or through the Multilateral Trading Facilities (MTF’s) that they operate.
By pooling and collating the combined traded data across the market execution venues, the highs, lows, volumes and volume weighted averages (VWAPs) may be published in real-time leaving the trades of market participants and their choice of execution platform anonymous to all except their own domestic regulator. Essentially this would allow for the transparency of the traditional Futures’ Pit to be married to the flexibility and innovation of the OTC market. In MiFID-speak, we would have a “Consolidated Tape” of almost the entire OTC market place.
Whilst not all trades in any given market are captured by the IDBs, the vast majority of key market risk factors are indeed hedged either through OTC through the IDB’s or on regulated exchanges. Expanded real-time collection and aggregation of trade data would easily cover enough of the market to allow meaningful supervision of market prices and volumes whilst maintaining integrity for all market participants. As this uses an infrastructure already in place it is close to costless to the end user and it may additionally encourage the further standardisation of trade identifiers, legal terms and post-trade processing. With the advent of straight through processing (STP) after deal capture, the real time nature of such IDB aggregated reporting would allow the market to move beyond the anodyne notions of a market open and close which have always been irrelevant to OTC markets. Indeed further “fixing” points that have often introduced excessive and artificial volatility into what should be a continuous ability to transfer risk may be negated by the VWAP transparency and commensurate wholesale execution methodologies. Further, these also enable tools such as volume and liquidity auctions to strike deal flow in less liquid products.
Whilst this methodology could be applied to derivatives markets as diverse as credit, interest rates, equity derivatives, FX, power and commodities; its limitations remain stark. Aggregated anonymous flows can only be reported where they meaningfully transact. There are vast tracts of OTC markets, both cash and derivative, where instruments trade rarely in a secondary market. Here supervisors have to rely on the curves submitted by participants to bridge the gaps between liquid instruments, based upon their mid-market indications.
The utility of daily aggregated intermediated data here is to validate these submitted curves by reporting the traded nodes as independent, consolidated & aggregated price sources. As a further dynamic indicator of risk, aggregated IDB data can also quantify market liquidity via the price and depth offered across the bid-offer spreads along a curve. Whilst this function is evident in the cash markets it becomes more valuable to market integrity in derivative markets where there has traditionally been less trade reporting. Here the market tends to transact the underlying factors that are employed to price instruments and model cash flows. This may involve volatility, correlations, the discounting curve or the “bet function” where observed trades diverge from theoretical models.
Following a decade of mergers and consolidation, London acts as the hub of the IDB sector with those firms whom are not domiciled in the UK still operating a large presence here. In this regard it is notable that the broking function can trace its modern origins to the re-opening of markets post World War II and the Bank of England imposition of fixed commissions in the FX market which required bilateral trades to be booked via an IDB in order to gain regulatory transparency (useful if your currency keeps devaluing). History may not repeat but it does rhyme. The trade body created in the 1950’s by the Bank of England to carry out this reporting is now called the Wholesale Market Brokers Association. It currently aggregates traded data daily to create indices such as Sterling Overnight Index Average (SONIA), Euro OverNight Index Average (EURONIA) and Repurchase Overnight Index Average (RONIA), whilst its sister association, the London Energy Brokers Association authors the industry leading indices on carbon, coal, emissions, gas and power. These benchmarks form the basis for OTC swap settlements and daily cleared marks via an aggregated VWAP methodology which allows trade “windows” to form the basis of reference pricing.
Should such real time aggregation methodology of price and volume can be rolled out across all the major wholesale markets covering both prices and factors, then the grossly unfounded allegations of opacity & “darkness” with concomitant systemic risk may be more demonstrably shown to be only a political construct. Indeed most practitioners will illustrate that the only major role of the OTC markets in the 2008 crisis was as the conduit to market of the policies and measures of the authorities to alleviate the funding squeeze. Systemic indeed.
