Aggelos explains that both the European Commission and the European Securities and Markets Authority have been explicit in their communication when it comes to derivatives trading in general and transparency around OTC products in particular, in the run-up to the introduction of Mifid II in January next year.
“No matter their nature, they should be subjected to pre and post-trade transparency,” says Patrice Aguesse, head of the market regulation division at the regulatory policy and international affairs directorate of the Autorité des marchés financiers. Aguesse told me that organized trading facilities (OTFs) were created because legislators wanted to offer more clarity on all types of derivatives trading platforms that might have been set up without a strong legal framework, such as broker crossing networks. Regulators understand the concerns of the market, which, says Aguesse, the European Securities and Markets Authority (ESMA) is trying to address as fast as it can.
Many fear that the over-the-counter (OTC) derivatives market will, as a result of OTFs’ reporting requirements, be disrupted or even vanish. After all, OTFs were partly introduced as a mechanism to make OTC derivatives reportable products. The feeling among many in the industry is doubt regarding the regulators’ transparency efforts. Not all share the same sentiments when it comes to reporting requirements, promoting an efficient and transparent market environment. Several sources expressed reservations as to whether the system for delivering that transparency, which requires an effective instrument identification system, will be fit-for-purpose. That said, there are concerns with International Securities Identification Numbers as a means of identifying instruments for the purpose of delivering transparency. There is still uncertainty as to how or whether it will work, and whether the regulators will be able to develop their systems by Mifid II’s January 2018 start date.
Many on the buy side are concerned that this dynamic of moving OTC products to “transparent” venues will result in them getting “caught out” by the transparency rules. Meanwhile, the sell side fears that by fulfilling these requirements, the whole rationale for not disclosing prices on these products will cease to exist.
Mark Croxon, Bloomberg’s head of regulatory and market structure strategy, says OTC products will move onto venues, triggering uncertainty in the short term. However, he says the OTC markets won’t necessarily vanish. “OTC products are naturally customizable,” he says. “I don’t think Mifid II will lead to the death of OTC trading because the fundamental reasons why people wish to customize derivatives to meet their risk or investment profiles will remain.”
Many fear that the OTC derivatives market will, as a result of OTFs’ reporting requirements, be disrupted or even vanish.
To most, however, OTFs will have a significant impact on the OTC market, even if Mifid II’s original purpose was never about changing the structure and the methodologies of the market. The sell side especially will experience wider changes and consequences, which could affect their business. Alex McDonald, CEO of the Wholesale Markets Brokers’ Association, says that since the trade reporting requirement for which OTFs were created is accompanied by other mandates, their introduction will have a marked effect on the European trading landscape. “One upshot is that the vastly increased cost of balance sheet and trading inventory will mean that it becomes cheaper for intermediaries to pass transactions straight through to venues than to interpose their own balance sheet,” he says. “When you combine these changes with those covering market abuse, benchmarks, short-selling and a series of money laundering regulations, there will be a move to push more trade flow through trading venues than was hitherto the case.”
McDonald sees a potential move from market participants toward the agency trading model. With this, he says, they will directly connect with and combine venue prices and show an aggregated feed to their onward clients. He also says that transparency would make post-trade processes—such as confirmation and affirmation, and clearing and settlement—more efficient. “The use of harmonized trade and product identifiers will also increase transparency and mitigate risk,” he says.