Redefining OTC Derivatives Trade Execution in Europe to Achieve Transparency

Alex McDonald, CEO, Wholesale Markets Brokers’ Association, asks how far along is Europe on redefining trade execution onto appropriate and organised venues with only six months to go before the G20 deadline?

The G20 Heads of State recommendations for decreasing risk, whilst increasing transparency in the derivatives markets, have focused on identifying the mechanisms to maximise the number of OTC derivatives transactions executed on organised venues and disclosed to trade repositories, as well as mandating the clearing of eligible derivative transactions through central counterparties (CCPs). With the end of the 2012 deadline looming for the introduction of new rules on increasing transparency in the OTC derivatives markets, set by the G20, there is still a long way to go. 

By the time November’s G20 comes along, of these three tenets of reform – reporting, clearing and trade execution,  it is highly likely that the former two will be resolved which will do much to mitigate systemic risk and provide the transparency which the G20 reforms were designed to create.  It is reform around trade execution for OTC derivatives which looks as if it will take some time longer to be resolved and agreed.  

As far as Europe is concerned, the proposed trade execution venue for what are currently OTC cash and derivative instruments is an organised trading facility (OTF) category. Simply put, the OTF is a trading venue which facilitates arranging and execution using both voice and electronic broking, particularly in a hybrid model that utilises multiple methods of liquidity discovery. While OTF operators would not take positions in the trades transacted, the scope proposed would allow them to facilitate liquidity using “discretion over how a transaction will be executed”. Further, the aim of the OTF category is to simply take current market practices which have evolved to efficiently discover liquidity, and wrap them into a venue with formalised conduct and reporting standards. We, at the WMBA, believe that OTFs’ capacity to arrange a wide variety of OTC trades and publish the results is integral to the regulatory mission and that any criticisms that the OTC markets are opaque will be dispelled by a well-constructed and rigorously monitored OTF.

Firstly, the introduction of OTFs will propel a wider array of prices into the public domain as eligible products will fall under the obligations of MiFID, MIFIR, EMIR, Short Selling and Market Abuse regulations. Live and indicative pre-trade price data from inter-dealer brokers are currently made available to the market through a host of electronic delivery mechanisms; and post trade reporting is similarly available, including via aggregation from the WMBA/London Energy Brokers’ Association (LEBA). Large OTFs will become primary independent providers of marketplace information where the operator has no stake in the performance of the underlying asset.

Secondly, the OTF category will dramatically expand the number and type of OTC transactions reported to trade repositories for assessment by prudential supervisors. The current, appropriately broad, definition promotes optimal trade capture regardless of market conditions – as recent bouts of volatility have shown, trading activity will shift towards voice-based intermediation in times of stress.

Finally, OTFs will defragment the marketplace and accelerate the adoption of central clearing for OTC products as the wide spectrum of trades being captured will maximise possible clearing eligible transactions. Importantly, the conveyance of transactions to CCPs will be independent to the manner of execution, yet more liquid and available reference prices will be created to facilitate the production of variation margin. Indeed, it is anticipated that the flexibility of execution methods and single points of access provided by the OTF structure will encourage non-mandatory products to be cleared centrally for netting and margin management purposes.

Recent market volatility has emphasised the vital role which voice broking plays in providing market participants with extra information around variables such as price discovery and liquidity, which cannot be accessed from looking at a purely electronic market. For example, in times of market stress, participants tend to go back to the phone to facilitate liquidity.

The majority of execution in these markets is hybrid, whereby market participants will assess price indications from an electronic system whilst engaging with voice brokers to arrange the terms of a trade and access deeper market liquidity beyond the electronic latency. The transparency from the broker provides market participants with commentary around price movements, market depth and transaction enquiries. In volatile market conditions, such as those which we are currently experiencing, the demand for multi-faceted information obtained via both voice and electronic means becomes all the more fundamental.

With only six months to go before the G20 deadline, a crucial part of increasing transparency in the OTC derivatives market, the trade execution piece looks unlikely to be agreed by the end of December. That said, the biggest area of progress has been that of trade repositories and their importance is not to be under-estimated. The value which trade repositories can deliver in terms of providing transparency around risk exposures and the holistic picture they can deliver of institutions’ exposures at any given time is critical to enhancing market stability and regulatory oversight. The utility and efficient functioning of trade repositories, however, will be greatly improved by a fully operating OTF category which will dramatically expand the number and type of OTC transactions which will be reported to trade repositories. Trade repositories should also mitigate the clumsy calls for trade venues to impose position limits.

OTFs as currently defined by the Commission are essential to the realisation of the G20 objectives as well as subsequent legislative initiatives which state that standardised OTC derivative contracts should be traded on designated trading venues. Additionally, OTFs as defined currently will also capture the maximum number of OTC transactions for central clearing and expand the number of OTC transactions which can be reported to regulators and supervisors. To those who have criticised the OTC markets as being opaque, a well constructed OTF is surely the perfect antidote.