Magazine Issues » December-January 2012

EXCHANGES: Comparing the market

SaleEuropean regulators want to shine a light onto the secretive world of derivatives trading. But critics say the laws would stifle the market and push up prices. George Mitton reports.

The process of buying an over-the-counter derivative hasn’t changed much since the 1980s. In most cases, a buyer picks up the phone to a sell-side bank, negotiates a contract and executes at a price that each party keeps private.

And yet the market itself has changed a lot. The nominal outstanding value of such derivatives exceeds $700 trillion (€500 trillion), according to the Bank for International Settlements, and most of this is hidden in dark pools, the private transaction networks where banks do their off-exchange trading.

European regulators want to change all that by bringing a large number of these instruments out of the darkness and onto regulated trading venues. The motive is to make trading more efficient and transparent. But could the new regime stifle the market?

The second version of the Markets in Financial Instruments Directive (Mifid II) is proposing a new system for buying derivatives. For people such as fund managers, who buy instruments such as swaps to hedge their portfolios, it could have many benefits.

Instead of picking up the phone, managers would go to one of a new class of trading venues called organised trading facilities (OTFs), which would compare quotes from several banks.

This process could mean buyers get a better deal, says Laura Cox, regulatory expert at consultancy PwC.

“You may find there is a reduced spread between the bid and the offer, and because there will also be a choice of clearing venues, your actual costs of trades may be lower,” she says. “For a manager that may mean they can achieve better returns.”

Cox expects the system to improve price discovery, make execution smoother and faster, and make it easier to identify counterparties.

The banks that sell derivatives may struggle to adapt at first but, ultimately, the new system would force them to be more competitive by improving service and lowering prices, which would be good for the industry. Proponents of the regulation say it is a pattern that has worked to open up several consumer markets to competition.

“If you want car insurance you go to a comparison site and get quotes from 50 different places,” says Robin Strong, director of buy-side market strategy at Fidessa. “It’s the intention of the regulators to offer that kind of comparison.”

And yet there are sceptics who dislike the proposals. An understandable gripe is cost. It could cost hundreds of millions of pounds to install IT systems to meet the requirement to report details of every trade to regulators (see box), and this will be borne by the industry.

A more thorny problem concerns the types of derivatives that will be forced onto regulated trading venues. The regulators have said that some of the more exotic types will be exempt, for instance, weather derivatives that insure against the cost of a bad summer. But that still leaves a large number of derivative types that are not yet standardised and not traded in large volumes.

Dark pools
If trading volumes are small, the market for these instruments would not be sufficiently liquid, say critics.

Another problem concerns large trades. At the moment, most large trades are executed in dark pools. But if they are brought onto trading venues, sellers could find that their actions move the price before they can execute as large a trade, or group of trades, as they want to.

This kind of transparency could be particularly costly for the sell-side. Whenever a bank sells a derivative it immediately begins searching for an opposite trade to balance its position. But if the market knows the bank is looking for that specific trade, the price ought to rise.

The upshot may be that some sell-side firms could be less inclined to trade derivatives and may charge a greater premium for taking the risk.

“Transparency to the broader market can, ironically, end up increasing prices to the end users,” says Eric Kolodner, managing director at Tradeweb.

The concerns about new regulation are not only from the sell-side. Some commercial buyers of derivatives are worried about the move towards transparency because it could reveal business secrets.

“They might consider that the information in terms of what they’re trading and how they’re doing it is commercially sensitive,” says Philip Morgan, partner at law firm K&L Gates.

He says some firms may be so worried that they would move to other jurisdictions to avoid revealing what derivatives they are buying. “We believe that some commercial firms who are doing their derivatives trading in Europe may even be considering the possibility of moving their derivatives trading operations out of Europe, possibly to Asia,” he says.

Time is of the essence
Despite the outcry, Mifid II has a strong political backing and parallels sections of the United States’s Dodd-Frank legislation. US lawmakers want to bring derivatives trading onto their own regulated venues, known as swap execution facilities, and the pace of reform means the US could set up its market infrastructure well before Europe.

“US legislation is moving faster under Dodd-Frank than in the EU,” says Cox at PwC. “It may mean market infrastructure is developed more quickly in the US and, for some global banks, they will be able to replicate that between the US and the EU.”

This would give these banks a head start in Europe. It could also mean that, while the European infrastructure is being developed, US trading venues would capture some of the derivatives trading that had happened in Europe. “It may be the time-lag that hurts  the competitiveness of the EU market,” adds Cox.

On this analysis, there seems to be a benefit to push through the Mifid II proposals to avoid losing business to the US. However, the time scale to implement Mifid II is likely to take longer than originally planned.

According to the original timeline, the European commission would reveal level two measures, including specific detail on what OTFs will be like, in 2013 or 2014. But it could take longer, during which the legislation will be subject to energetic lobbying in Brussels.

Even after this draft there will be a long way to go. Regulators cannot force derivatives trading onto new venues unless the market infrastructure is there to support it, and the necessary IT spend requires a long lead time from the sell-side banks who will pay for it. These are further reasons why the time frame may be pushed out.

But despite the delays, the reforms seem sure to be implemented in some form. Opponents of the regime would be best to focus their efforts on what derivative types are excluded. If the law were to be restricted to only the most frequently traded derivative types, there would be less disruption to the market and the problems about liquidity would be avoided.

However, this solution might allow many of the big trades to remain in dark pools, a scenario that regulators are keen to avoid. The conclusion to this question will emerge in the coming months as regulators and lobbyists hammer out the detail of the proposals.

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