It Might Be Electronic Trading, But It's Still OTC to Me

Following a recent interview with Kevin McPartland, principal and head of fixed-income research at industry analyst firm Tabb Group, I’ve been having trouble reconciling how the over-the-counter (OTC) swaps market will operate electronically under the Dodd–Frank Act.

Sell-Side Technology has been following the industry developments on this topic and what comes to mind is the saying that simply calling a dog’s tail a leg doesn’t make it a leg. Similarly, calling an OTC market an electronically traded exchange-based market doesn’t make it one.

The industry has seen the OTC market go electronic with the various platforms provided by the inter-dealer brokers and the third-party fixed-income trading venues. But I question some of the benefits that the US Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) promise under the new regulatory regime.

First, there is the issue of seeing tighter spreads and smaller order sizes when trading goes electronic. Yes, in the equities, options, futures, and foreign-exchange (FX) markets the order sizes did get smaller and the spreads tightened, but all of those markets have something that the OTC swaps market doesn’t: a retail investor presence.

When there’s a retail order flow in a market, institutional investors do their best to hide the institutional nature of their orders among the smaller retail ones. Hence, they slice and dice the orders so that the high-frequency traders will not pick off their trades. In the swaps market, everyone is a professional investor. There are no investors looking to add swaps to their individual retirement accounts or grandparents opting to fill their grandkids’ college funds with them.

The second issue is the heavy-handed prescriptive nature the CFTC is taking. It has not come out with the regulations mandating order-size increments yet, but I can see that coming. It might be a de facto standard based on the trading habits that develop on the various swap execution facilities (SEFs).

This leaves an interesting question about how investors will deal with odd lots. Considering the bespoke nature of these products, will the regulators force investors to deal only with round numbers, or will there be some mechanism for investors to get the investments they need?

It is your call, CFTC.