Elements of MiFID II, and specifically execution of OTC derivatives via OTFs, remain ambiguous. Lynn Strongin Dodds explores the areas of uncertainty including the status of FX swaps, the definition of sufficient liquidity and how the derivatives market is preparing accordingly.
Wading through the 800 page MiFID II consultation paper with as many questions is not an enviable task. The wide ranging topics will certainly elicit different responses and organised trading facilities (OTFs) are no exception. Opinions will vary but all agree that they should not be confused with their American swap execution facilities (SEFs) cousins as they are two very distinct models.
To begin with, SEFs, which went live in the US earlier this year, ushered in a new era by standardising OTC derivatives via electronic exchanges and central clearing. OTFs which are also a new venue category are often described as a halfway house between Multilateral Trading Facilities (MTFs) and so called regulated markets or exchanges. They differ from the other two in that they will only be able to trade non-equity instruments and while nothing yet is set in stone, many believe this means bonds, structured products, emission allowances and derivatives. OTF operators will also be able to trade on a proprietary basis on their own platform in illiquid sovereign bonds and trade on a matched principal basis in all bonds.
The other major distinguishing feature between European and US venues is that while OTFs will be required to disclose pre-trade and post-trade data they will be allowed discretionary execution and limited matched principal trading. It is broken down into two levels and covers decisions regarding the placing or retracting of an order as well as choosing not to match a specific client order with another order available in the system at a given time, provided it is in compliance with specific instructions and best execution obligations. By contrast, the Commodity Futures Trading Commission (CFTC) has made it clear that SEFs must offer non-discriminatory access and not favour one type of participant over another.
“On so many occasions we see SEFs and OTFs being used interchangeably but it is a mistake to think of them in the same way,” says David Clark, chairman of the Wholesale Markets Brokers’ Association (WMBA), an industry group that represents inter-dealer brokers. “There are key differences between the two, with OTFs covering both voice and electronic trading. SEFs, on the other hand, facilitate electronic trading after which a trade has to be cleared and reported. To us, the use of OTFs is really codifying already existing market practice whereas in the US SEFs have been mandated as a venue in their own right.”
Christian Voigt, senior regulatory adviser at Fidessa also believes “OTFs have unique features and are not exactly like SEFs. They are both part of the G20 recommendations to reduce OTC trading and push as much as possible to exchanges and through central clearing. European legislators, however, recognised that there are some highly complex trades that still need human interaction. I see them as a hybrid in that they are not a typical trading venue but they do have some similar regulation.”
One of the big questions is how do I match orders and why does Europe need discretionary OTFs? Is the US regulator’s stance a means of supporting the agency model, while Europe favours dealer markets, or are their other considerations? At the moment, there is still a lot of uncertainty and unanswered questions. With so much up in the air, those firms offering trading in derivatives markets on a global scale still face uncertainty about the future of swap markets.
Another source of contention is the definition of “sufficiently liquid.” According to the Futures Industry Association (FIA), MiFID II and MiFIR contain different definitions of ‘liquid market’ and apply the concept differently for equities and non-equities. Specifically, the European Securities and Markets Authority (Esma) states that liquidity tests and assessments in other pieces of European legislation serve different regulatory purposes and are, therefore, independent of the liquidity assessments for MiFIR.
ESMA has put forward several possible criteria for measuring liquidity, including the average frequency and size of transactions, number and type of market participants and the average spreads. The FIA Europe notes though that it has not yet set out how these criteria should be combined or measured in order to properly assess whether a product is sufficiently liquid to be subject to the trading obligation.
“The term is definitely problematic,” says Jeremy Taylor, specialist in derivatives at consultancy Rule Financial. “It is more geared towards the lit market where there are orders that are executed on exchanges and centrally cleared. Non-equity products can be complex instruments and there needs to be a single definition that can be applied to a range of asset classes.”
This will not be an easy task. “A large amount of high quality data will be needed to recalibrate thresholds for sufficient liquidity but getting everyone to agree on the definition of liquidity will be difficult, “ says Taylor. “For example, is it the types and frequency of life cycle events?”
Matt Gibbs, product manager at Linedata, agree adding, “One of the issues is that liquidity is too broadly defined and there are differences between MiFID, EMIR as well as the CFTC. There needs to be much more granularity and detail. Liquidity is easy to define if it is an equity on an exchange traded venue but much more difficult in the fixed income world.”
Another area of ambiguity is the status of FX swaps. At the moment, they are defined as MiFID instruments which mean they could also be designated as OTF assets which would compel them to have a clearing mandate which is not required in the US. Under Dodd-Frank, only options and non-deliverable forwards (NDFs) are to be cleared and potentially traded on SEFs, and market participants believe that Europe should follow the same path. While Esma is aware of these arguments, it is unclear as to the outcome.
Overall, the current MiFID II papers published by ESMA contain little detailed analysis of the OTF and this lack of specific implementing measures means it is difficult to gauge how these venues will function and the role they will play. As Matt Woodhams, head of e-commerce EMEA at GFI Group, put it, We know that the operator of an OTFs can’t also be a systematic internaliser. What we don’t know though is what the interaction will be between the different platforms and where an OTF sits in the new world. The concept is there but it is not clear at this stage how it all will play out.”
While most brokers are considered to be systematic internalisers (SIs), they have made limited use of the trading mechanism, instead preferring to use broker crossing networks, which have no pre-trade transparency obligations. However, under the MIFID II blueprint, broker crossing networks will be banned while SIs will be under greater scrutiny and have defined parameters. For example, ESMA has set out three options for changing standard market size along with its proposed cap of 4% per venue and 8% globally for dark venues.
On the whole, one of the main aims of the regulator is to bring greater transparency into the markets, according to Daniel Simpson, research analyst, JWG Group Limited, financial services regulation consultancy, “I think the definition is extremely wide because they want to capture as much dark trading as possible. This raised concerns from trade associations who do not want to see dark pools removed completely. It is a timely and expensive process to make everything standardised and people also like the anonymity of dark pools. Ultimately some trades are dark because they need to be in the interests of fairness.”
Gibbs agrees, adding, “From the buy side perspective large asset managers across the world like to do some trading across a broker’s internal crossing network. They like to keep some orders close to their chest. For example, working a big block can be difficult when it goes onto exchange. Regulators, however, want to push anything that is remotely dark into the light.”
It would be simple to say all will be revealed in early August when the responses to the consultation paper are in. It will though only be the beginning and uncertainty will continue to hang over the markets. Given the thicket of regulation coming down the pipeline, OTFs which are not expected to make their debut until 2017 are far down the priority list but this will change once the deadline inches closer. In the meantime, both buy and sell side firms are busy working individually to help put meat on the bones while industry groups like the FIA Europe has joined forces with the WMBA and the Association for Financial Markets in Europe to develop a coordinated approach not only to OTFs but MiFID II in general.
