ft special report derivatives

7/30/2019 FT Special Report Derivatives

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DERIVATIVESFINANCIAL TIMES SPECIAL REPORT | Friday November 4 2011

www.ft.com/derivatives-nov2011 | twitter.com/ftreports

The d er iv at iv esindustry in the USis on the thresholdof a new era.

Ahead of the rules thatwill emerge in the comingmonths in the wake of theDodd-Frank Act on finan-cial regulation big marketparticipants are embracingreforms.

K ey a re as o f c ha ng einvolve the clearing of thebulk of over-the-counterderivatives which aredirectly traded between par-ties mandatory post-tradereporting and the trading ofstandardised derivatives onSwap Execution Facilities(SEFs) or exchanges.

While final rules are still

being written and will notemerge until later this yearand into 2012, those heavilyinvolved in OTC derivatives international banks, inter-

dealer brokers and provid-ers of electronic tradingplatforms have not beenidle.

The big dealing banks arejockeying for position inspite of the likelihood thatmore transparency in swapstrading will reduce reve-nues.

We h av e p u t a l ot o f

resources towards makinsure we will be ready tclear and electronicalltrade derivatives when thrules are finalised, sayJon Kinol, global head orates at Credit Suisse.

Liquid sectors of fixeincome markets will trad

Market prepares for transparencyMichael Mackenzie

says the industryhas not been idleahead of changes

to trading andreporting rules

Continued on Page

FinancialMarketsseries


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FINANCIAL TIMES FRIDAY NOVEMBER 4 2011 FINANCIAL TIMES FRIDAY NOVEMBER 4 2011

rivatives Deriva

tributorsel Mackenzie

kets Editor

eitzmano and Midwestpondent

y Grantding Room Editor

ry Meyers Reporter

emoskets Reporter

Miltonssioning Editor

Steven BirdDesigner

Andy MearsPicture Editor

For advertising details,contact:Ceri Williams on:+44 (0)20 7873 6321;fax: +44 (0)20 78734296;email: [email protected] your usualrepresentative

de This Issue

crisis gives clearing a boostERIVATIVES There is a sense in thetry that the change is a trend, not aage 4

native hedging strategiesANGE TRADED FUNDS Traders are

singly using them, as the cost of otherques increases, but the complexity ofproducts is starting to worry regulators

6

venues aim to provide choicePEAN REGULATION October saw thencement of keenly awaited finalsals for reform to equities, derivativesxed income markets. Transparency ismmon thread Page 6

stry hopes longer delaysmean looser rules

EXECUTION FACILITIES

wo US regulators havet agreed how these

rading venues will

7

Marketsgear up

forreform

electronically, but the lessliquid areas will continue torely on human interaction,he adds.

Kevin McPartland, direc-tor of fixed income researcha t T ab b G ro u p, s ay s arecent survey revealed thatthe vast majority of top andmid-tier dealers told the USbased consultancy they areready for the new rules andw a it ing t o s e e t he finalguidelines.

Despite the unknowns,complexities and costs, the

dealer community feels thatit is ready for change, saysMr McPartland.

Yes, lobbying will con-tinue on both sides and poli-t ics w ill pe rs ist , but t hedealer community sees thea dvant a ge s o f a mo st lycleared swaps market.

But the potential for therule-making process to bede laye d w e ll int o 2012 iscausing concern that pre-paring for change may bemore costly than it needs to.

There is a lot of industrypreparation taking place,but market participants andpotential SEFs face an inter-esting catch 22, in that thereare concerns they may godown the wrong path beforethe rules are finalised, saysSonali Das Theisen, a direc-tor of credit trading at Bar-clays Capital.

A fair amount of [creditdefault swap] index tradingis now electronic, whereassingle names [CDS thatpro te ct a g ains t a s ingleasset] are lagging as theindustry waits to see howthe SEF rules are finalised.

In spite of concerns aboutfinal rules for transactingswaps being too strict, thederivatives industry is mak-ing s t ride s in cle aring,building infrastructure andputting in place electronictrading systems.

Elect ronic t ra ding isaccelerating ahead of the

final rules being written byr e gu l at o rs , s a ys L e eOlesky, chief executive ofTradeweb, an operator ofelectronic trading platforms.

Our business model isbenefiting from the prospectof swaps trading in a regu-lated environment and on aplatform that is transparentand open to investors.

T r ad e we b r e ce n tl ya nnounced a 90 pe r ce ntincrease in notional tradingvolume on its global multi-dealer-to-client interest ratederivatives platform for thethird quarter of 2011, com-pared with the same periodof last year.

Tradeweb, Bloomberg andMarketAxess, who all offerelectronic derivatives trad-ing, have all tested theirplatforms with trades fordealers and institutional cli-ents that are seen as beingSEF compliant under theproposed rules.

Rick McVey, chief execu-tive of MarketAxess told arecent conference on SEFs: T rading t e chno log y isre ady t o da y. M a ny o f ushave critical mass in ournetworks, we have 900 insti-tutions, firms and 80 deal-ers, similar to competitors.

At the same conference,Jeff Gooch, chief executiveof MarkitSERV, which proc-esses OTC trades, stressedthe importance of managingthe introduction of regula-tions.

Final rules are needed sowe can tweak existing plat-forms and test systems, hesays. Most participants say

they need two months.Among the leading inter-

de ale r bro ke rs, o r IDBs,such as Icap, BGC Partners,Tradition, GFI and TullettPrebon, electronic trading ofswaps in Europe is acceler-ating and these intermediar-ies for banks are positioned

to introduce dollar SEFsonce the rules have beenclarified.

W e a re w e ll pla ce d t otake up the new regulationsso technology will not be aproblem, says Ron Levi,chief operating officer atGFI. We have very agile

development teams acrossthe IDBs but clarity aroundthe regulation is needed.

M r M c Pa r tl a nd s a ysT a bbs s urvey s ho we d:There is some consensusamong those surveyed thatplatforms with an alreadyliquid electronic cash mar-

ket have an advantage.He adds: This bodes par-

ticularly well for BGC Part-ners, Bloomberg, ICAP, Mar-ketAxess, Tradeweb and atleast one new SEF entrant.

The clearing of swaps isalso rising with more tradesplaced with central counterparties, or CCPs.

W hile t he bus ine ss islargely bank-to-bank anddominated by LCH.Clearnet,the London-based clearingho use , fo r int ere st ra t eswaps and ICE Trust forcredit derivatives, the CMEsaid it set monthly clearingrecords in September forboth products.

Electronic tradingis acceleratingahead of the finalrules being writtenby regulators

Virtually there: markets are preparing for more electronic trading of derivatives Bloomberg

age Illustration: MEESON

Continued from Page 1

US regulators pushing tosend more derivativesdeals to clearing houseswould do well to study

energy markets.Years before the Lehman Broth-

ers collapse and the AIG bail-out,traders in over-the-counter natu-ral gas and oil derivatives startedclearing their swaps.

The impetus was the 2001 bank-ruptcy of Enron, then dominantin US gas markets, and creditdowngrades of other energy trad-

ing companies. The crisis shockedenergy market participants andforced them to look for safer waysto hedge supplies.

T he Ne w Yo rk M e rca ntileExcha nge , no w pa rt o f CM EGroup, and the fledgling Intercon-tinentalExchange began allowingbilateral trades to be transferredto clearing houses, which acted ast he buye r t o e very s e lle r a ndseller to every buyer, shiftingcredit risk away from individualcounterparties. Traders had topost collateral to keep positions.

At first, the market looked at itand said, I have all these triple Acounterparties. Why would I wantto incur the extra cost of clear-ing? says Chuck Vice, the ICEpresident.

The whole Enron situationchanged that quite a bit. Every-body looked around and said: Ifmy highest-rated, largest counter-party can go bankrupt, prettymuch anyone can go bankrupt.The pendulum started to swingfairly quickly, Mr Vice says.

Technology made clearing eas-ier, as some trading shifted fromtelephones to instant messages toscreen-based platforms.

At ICE, the share of over-the-counter energy trades that werecleared grew from 2 per cent in2002 t o mo re t ha n 95 pe r ce nttoday. Daily volumes handled byClearPort, the clearing servicethat Nymex launched in May 2002,grew from 24,000 on average in2003 to almost 450,000 so far thisyear. Volumes peaked at nearly500,000 in 2009, after Lehmans

failure.Clea rPo rt w a s born o ut o f

necessity, says Mike Prokop,managing director for energy andcross asset-class products at CME.ClearPort now also handles for-eign exchange, interest-rate andother derivatives.

The trend towards clearing hasenabled new energy swap dealersto break into markets once domi-nated by Wall Street banks andlarge oil companies.

Previously, a trader had to signmountains of documents witheach counterparty to certify itwas able to strike deals underswaps rules. The process couldtake months and still left tradersat risk of anothers default.

Its been great for everyoneexcept those whose business mod-els required opacity, episodicliquidity and the ability to serve

as a gatekeeper for investors,says Michael Cosgrove, a manag-ing dire cto r a t G FI G roup, a ninterdealer broker.

One smaller dealer is GenevaEnergy Markets, an 11-personoperation based in New York andDublin. Ins ide G EMs mo de s toffice near Wall Street, computersmake laser-gun noises each time atrade goes through. At times itsounds like a shoot-out in a sci-ence-fiction movie. The companyis one of the most active tradersof cleared oil swaps.

We only do cleared trades. Wewouldnt take Exxons credit ift hey as k ed us t o, s ays MarkVonderheide, GE M m anag ing partner.

Its not a matter of suggestingsomeones not credit-worthy. Whybother to add that to your list ofthings to think about?

He says other market partici-pants initially resisted clearing,but volumes took off after 2007.

Trading counterparties real-ised it cost them real money ifthey werent willing to clear theiro il s w ap t ra de s , be ca us e t hecleared-only bids or offers wereregularly the best in the market.

Mr Vonderheide, a former sen-ior trader at banks and Vitol, theoil trading house, says that nowmost of the oil swaps market iscleared. Its certainly a model forhow a very active, volatile andlarge market can organise itself todo a massive percentage cleared,he says.

Not every trader wants to clearits positions. Posting margin col-

lateral can be a drainnies cash. The US Act on financial regnot require commerc

ers, such as gas drrefiners, to clear theirtrades.

Under the reforms, sswaps deals between traders must be cleat o rs a re s t ill w rit iimplement the legisla

Some say that whian appealing exampmarkets, it will noneatly to other derivas credit default swap

In the energy buma rke t pe rce ive d a[clearing]. It grew without anybody telldo it, says Craig Pirsor of finance at the UHouston.

An example for regulators to studEnergy

The 2001 bankruptcy ofEnron shocked marketparticipants into findingsafer ways to trade,says Gregory Meyer

Enron changed thesituation. Everybodylooked around and said:If my highest-rated,largest counterpartycan go bankrupt, prettymuch anyone can

Crude oil tank in Indonesia: the Dodd-Frank Act will not require end-users, such as gas drillers or oil refiners, to clear derivatives tradesensler,hairman,or rules

t of 2012


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rivatives

The collapse of Leh-ma n Bro the rs in2008 was undoubt-edly devastating for

obal financial indus-n d h a d p r of o un don the economy.

CME Group, the big-utures exchange in, it also gave rise toortant opportunity.fear of counterpartyovoked by the bankse held out the prom-t the over-the-coun-

ivatives market theof which dwarfs listedts might be pushedar through centralrpart y cle aring such as CMEs,

ing the group withcant new business.

0 agreement in 2009e Dodd-Frank Act

gislation passed lasthat aims to overhaulial regulation bothged a legal mandatemany OTC swaps ase to be cleared.offers clearing facili-credit default swaps

a type of financialct that became muchw e ll know n in t he

of the crisis.the group has beento the punch by the

n-based clearing busi-f IntercontinentalEx-e, which establishedance in CDS throughsortium arrangement

he biggest dealers.ad, CME has focusedf its efforts on inter-

e swaps (IRS), a huge that is a natural fit

t he C hi ca goges dominant posi-n US int e res t ra t e.

IRS pie is much big-an CDS. Whereas thearket ended last year

a notional value ofbn, according to theor International Set-

ts, the IRS market isa t $465,000bn, o r

han three-quarters ofire OTC market.eve r, uncert a int ythe implications of

Frank have contrib-t o s low e r prog res sm i gh t h a ve b ee n

ed at CME., after the Lehmane, with the passing ofthe urgency of riskon diminished andmise of large cleared

es failed to material-

n recent months, vol-have shot up. CMEd $5m in IR S co n-

t ract s in M a y, $190m inJune, $400m in July, $1.24bnin August and $35.47bn inSeptember.

Alt ho ugh t he no tio nalvalue of cleared volumeslevelled out in October, it isstill on course to be in thetens of billions of dollars.

Cleared CDS volumes alsowent up from $10m in Julyto $6.46bn in September.

To a large extent, theseincreases are in response tothe eurozone crisis.

Just as the Lehman col-lapse prompted a rush toreduce counterparty risk,

the debt crisis in Europehas given OTC clearing asecond wind.

Kim Taylor, CMEs headof clearing, says: In thepa st co uple o f mo nths ,weve seen a significantuptake in OTC clearing astraders respond to the euro-zone debt crisis and reviewtheir counterparty risk pro-files.

That is echoed by DanielMaguire, head of SwapclearUS t he O T C s e rvice o f LCH.Clearnet, Londonsma in cle a ring ho use which competes with CME.

The need for counterpartyrisk reduction is drivingdemand, he says.

At the same time, thosein the industry say tradersare also moving to clearingto be ready for when man-dates will apply.

Gary Gensler, chairmanof the Commodity FuturesTrading Commission, told afutures conference in Chi-cago in October that a gov-ernment mandate forcingt he mo s t s t anda rdis edswaps to be cleared couldcome into effect by April,with the entire industry

ha ving t o co mply by t heend of next year. Many arenot waiting for those dead-lines before acting.

Ms Taylor says CME hasmore than 500 clients clear-ing OTC trades, with manymore in the pipeline and as harp incre a se in clienttesting. She also says CMEhas been forced to bring for-w a rd it s product la unchd a te s b e ca u se o f t h es t re n gt h o f c u st o me rdemand.

F lo yd C on ve rs e o f LCH.Cle arne t s a ys hisorganisation is increasinglyseeing asset managers who will not be mandatedto clear in the US until theend of 2012 jumping thequeue and beginning toclear swap trades.

Chris Perkins, head ofderivatives clearing at Citi-

group Global Markets, sayshis bank is setting up 2,000accounts for clearing.

He adds that dealers arealready offering their cli-ents cross-product margin-ing (the cash or securitiesp o st e d a s c o ll a te r al )between swaps and futures,even though exchanges can-not yet do this, and regula-tors could ultimately decidenot to allow the practice.

The sense in the industryis that the move to clearingis a trend, not a blip.

Volatility and uncertaintywill eventually recede, butas Mr Converse notes, bythen clearing will be man-dated.

Revenues from clearingswaps may be becoming animportant part of CMEsbusiness, but the exchangestill hopes that the over-haul of financial regulationwill also cause business tomigrate from OTC to its tra-ditional listed markets.

A key factor may be therelative costs of clearingswaps and futures: margin-ing co s t s fo r t he fo rmerma y be up t o five t imeshigher. William Cleary, amanaging director at Bankof America Merrill Lynchsays: Theres a whole loadof customers looking at thecost of trading OTC. Wellsee a big increase in the useof futures products.

Kevin Foley, a partner at

Katten Muchin Rosenman,a law firm, agrees. Noto nly w ill w e s e e a s hiftfrom uncleared to cleared,but a ls o fro m s w aps t ofutures, he predicts.

Cra ig Do nohue , CM Echief executive, sees this asa shift that will shape bothOTC and listed markets.

As people look at thec o st s o f d oi n g s wa p s,theyre looking at alterna-t i ve s [ s uc h a s l i st e dfutures], he says.

Th at i s g oo d f orexchanges in both senses.The Big Game may be theconvergence that happensfor market users.

Euro crisis gives clearing a boostderivatives

e is a sense inndustry thathange is a

d, not a blip,Hal Weitzman

A new view: because of the eurozone crisis, traders have looked again at their counterparty risk profiles Maurizio Gambarini

Theres a wholeload of customerslooking at the costof trading OTC.Well see a bigincrease in the useof futures products


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rivatives Deriva

The tussle between regulators over howover-the-counter derivatives will trade inthe US has already been drawn out andmay run well into 2012.

While this is causing frustration in thederivatives industry, more delay couldbring a silver lining in the form of lessprescriptive rules in the US, and couldallow European regulators to formulatetheir rules and thus limit the implementa-tion gap between the two regions.

The main message we are hearing fromthe industry is that they should be left todecide how to trade swaps and that therules not be overly prescriptive, saysKevin McPartland, director of fixed incomeresearch at Tabb Group.

US-based swap dealers, interdealer bro-kers and institutional investors are increas-ingly voicing their concern at how pro-posed rules will flesh out the Dodd-FrankAct in the area of new trading venuesknown as Swap Execution Facilities, orSEFs.

In the US, the Commodity Futures Trad-ing Commission has the task of regulatingthe vast majority of swaps, includinginterest rate, commodity, currency andcredit derivative indices. The Securitiesand Exchange Commission is responsiblefor regulating security-based swaps, suchas credit derivatives for individual compa-nies.

A key problem for the industry is thedifferences in the approaches of the CFTCand the SEC to interpreting swaps tradingunder Dodd-Frank.

At a conference on SEFs held in NewYork in October, Gary Gensler, chairman ofthe CFTC said he hopes that final SEFrules will be written by the first quarter of2012. But, Scott O'Malia, one of five CFTCcommissioners, also told the conferencethat final SEF rules could well take longer,given the differences between suggestedCFTC and SEC rules.

In particular, the SEC has proposed notto limit SEF trading protocol and to allow

voice broking, rather than stipulateelectronic trading as the CFTC has.

The big worry is that the stricterproposed rules from the CFTC willimpair swap trading liquidity, as themarket is typified by large tradesizes often more than $100m atinfrequent intervals.

While the CFTC wantst o s ee s wa pusers requestfive quotesbefore theytrade, theS E C h a sma nda t e dt hat ma r-ket partici-p a n t sre que s t a

quote from at least one banlargely the current practice.

Many in the industry favoapproach, as its rules are seen a

This lighter touch approaallies in Congress, with a housover the summer the SEF Act that seeks to limit the rCFTC.

The bill would correct a numin the current proposed regulatotation and better align the prowith Congressional intent, sVoldstad, chief executive of tional Swaps and Derivatives the industry trade body tosional committee last month.

These flaws have the potentcantly and adversely affect the the swaps market by reducing lchoice and by increasing cosmately risks for OTC derivatiparticipants, he added.

Agreeing final rules for SEFstake well into 2012 and keep potties cooling their heels for som

The industry hopes that a lonfinalising rules and reachingbetween the SEC and CFTC wless strict guidelines.

There is a sense that regulaing to harmonise their rules acerned about adversely impaity, says Sonali Das Theisencredit trading at Barclays Capi

While a delay in finalising rtrating and is weighing on the mfor the long term benefit of themarket that the rules be writtand do not harm market liqadds.

Ultimately, further delays could see convergence with the

Policymakers in Europe are sdefine SEFs and how they wiconvergence would reduce costrict US rules could push trada less demanding region.

If the final rules are flexiblechanged in the future as the m

ops, then there is pgreater internation

tion, says Chmanaging direcan interdealer

We would the rules finawith the propeimpleme nta t ioapplied, but to

there is a delaco me if it me a

mo re de ba t e a nrules do not

ity, he

bulent three monthsding have brought a

n volatility. The Chi-B oa rd O pt io ns

nge Volatiliy Index,n as the Vix, doubled

ust, and has stayedor the longest timehe midst of the finan-

sis.t h e p as t , h e dg i ng t volatility typicallyed derivatives, both

nge-traded and over-unter, that could payrices moved sharply.t he rising price o f trategies as volatilityayed high, plus thect of regulations that

ma ke O T C t ra ding xpensive in the short

have given rise to thepments of alternative

ng products, in theof exchange traded

y traders say that, asto ry s crut iny ha sse d, t hey a re no wrequently turning towhen in the past theyhave used options or to hedge.

dge funds have beenthis for a long time.a re a ve ry liquid,w a y o f put ting ao n, s a ys Brito n

head of US ETF salesading at Newedge, aage.now, he says, institu-

s uch a s pe nsio nand foreign clientsng the US ETF mar-

omething happens ine a n d y o u k n ow

hings going to hap-financials, you can

a hedge quickly andy when theres high

ty and [therefore] ar cost of hedging, he

tility has increasedasset classes. The

Skew index, whichres the ratio betweeno n a la rg e ma rke t

ve rsus a s t ea diera nd is a co mmo nfor the price of insur-ose to its highest inyear in October.

it volatility, as meas-y implied volatility ofX credit default swapty index, reached itst in o ver a ye ar,

ing to Barclays Capi-did currency volatil-

ity, measured by DeutscheBanks CVIX index.

ETFs were devised in theearly 1990s as a replicationof the index funds investorsused to generate tradinggains or get broad exposureto an asset class.

But in recent years moreco mple x pro duct s t ha tderive their prices from vol-atility indices or provideinverse or leveraged returnso n a n underlying indexhave been launched.

ETF assets have grownby about 50 per cent since2009, to just under $1,000bnat the end of September,according to State StreetGlobal Advisors.

Meanwhile, notional out-standing amounts of OTC

derivatives have shrunk by10 per cent, according to theInternational Swaps andDerivatives Association the industry body as G20nations begin to requirethat all OTC trades are cen-trally cleared and traded onan exchange, making the

market more expensive.In the same period, the

options market has grownby less than 2 per cent andmuch of the trading vol-ume, says the Tabb Group,a f i na n ci a l i n du s tr yresearch company, is attrib-utable to the rise in optionson ETFs.

A c co r di n g t o H e nr yChien, an analyst at Tabb,ETF options have been abig source of options vol-ume and now account for37 per cent of volume untilAugust 2011, an increase of39 per cent over last year.That compares with growthof just 14 per cent for index

options and 3 per cent forsingle-stock options.

Options are the mosteffective and efficient wayto hedge because they areperfectly correlated, saysJay Pestrichelli of ZEGAFinancial, an investor advi-sory. But they can get veryexpensive when volatilityrises. ETF indices can bea che ape r a lt erna tive ,be caus e t he y a re o fte nde epe r a nd mo re liquidmarkets, he adds.

Increasingly, there arecomplex ETFs that cater tospecific risks.

T h ey i n c lu d e f i xe dincome ETFs for corporatebonds, Treasuries or sover-e ign bo nds , o ptio ns o n

which are much more liq-uid than the largely over-the-counter market for bondvolatility products.

Befo re , yo u ha d co m-modity or bond traders noteven in the same buildingas equity traders, says MrRyan. Now they can pro-vide liquidity to each other,and traders are always look-ing for new and cheaperways to hedge.

While ETFs that rely onthe Vix are roughly $5bn inassets, and the overall uni-verse of inverse or lever-aged ETFs make up only$30bn, versus $1,000bn int o ta l a s se t s , t he y ha verecently aroused regulatoryconcern.

The US Securities andExchange Commission saidduring a US Senate hearingon ETFs in October that itwas looking into how toregulate such products.

BlackRock which spon-sors about 40 per cent of allET Fs by a s se t s, mo st lyplain vanilla index prod-ucts has proposed morecomplex products shouldnot be classified as ETFs.

T he difficult y is t ha treturns on complex prod-ucts are not straightfor-ward.

ETFs based on futures,for example, have a built-incost as contracts roll over.

An investor holding aninverse Vix futures ETF

from 2008 until mid-2011,w hen vo lat ilit y s harplydeclined from record levels,would have actually lostmo ne y, a cco rding t o M rPestrichelli.

But despite those worries,many tactical and short-term traders have increasedtheir use of complex ETFs.

N i ck C h er n ey , c h ie f i n ve s tm e nt o f fi c e o f VelocityShares, a providero f v ol at il i ty -l i nk edexchange traded products,s a ys : T ra ders w a nt t omove out of over-the-coun-ter land and out of hedgefunds into more transparentand liquid instruments,

nterest of marketsnd regulators grows

s

ers use thes as alternativees but the

plexity of someucts is a worry,Telis Demos

BlackRock sponsors 40%of all ETFs by assets

Hedge funds havebeen doing this fora long time. ETFsare a very liquid,quick way ofputting a hedge on

Industry hopeslonger delays willmean looser rulesSwap execution facilities

The two US regulatorshave not yet agreed howthese new trading venueswill work. Michael Mackenziewrites on the implicationsfor the market

G

The European Com-mission last monthunveiled its keenlyawaited final pro-

posals for a sweeping over-haul of the regions equi-ties, derivatives and fixedincome markets.

The document, known as

the Markets in FinancialIns trument s Dire ct ive(Mifid), contained details ofhow Brussels believes over-the-counter (OTC) deriva-tives trading should evolvea nd is pa rt o f Euro pesvis io n fo r ne w ma rke tstructures.

Mifid was enacted in 2007,to inject competition intoshare trading across theregion. But it has morphedinto a far larger project thatcovers on- and off-exchangederivatives, fixed income,bonds and structured prod-ucts.

The final proposals aremarked by a single policy

o bject ive : fo rcing mo retransparency on markets,a s r e gu l at or s f o ll o wthrough on a commitmentmade by G20 nations in 2009to clean up the financialsystem.

Mifid, a companion initia-tive called Mifir and athird called the EuropeanMarket Infrastructure Regu-lation are Europes equiva-lent of Dodd-Frank in theUS . T he US a ct re quiresthat trading in OTC deriva-tives be moved away fromthe banks that have longdominated, on to exchangesand electronic platformsca lled s wa p e xe cut ion

facilities (SEFs).In Mifid and Mifir, Euro-

pean regulators have gonefurther. They have createda third category of tradingplatform in addition toregulated exchange andmultilateral trading facil-ity (MTF), the two catego-ries used for share trading an organised trading facil-ity (OTF).

All three categories willoperate under broadly simi-lar transparency rules andprocedures.

T he ide a is t o crea t e amenu of structures formultiple kinds of financialproducts to be traded, while

ensuring they adhere to thesame broad transparencyrequirements so that regu-lators and investors canmore easily monitor mar-kets and track prices.

Y et O TF s h a ve b e engiven some discretion onhow to execute transactions a ke y co nces s io n t ha tdealers in the OTC deriva-tives markets have seizedon as a sign they will not beforced to transact deriva-tives on exchange-likeplatforms where prices areposted for all to see.

The exchange, or centrallimit order book model isfavoured for SEFs by US

regulators.But OTC dealers worry

that if the US were to pickt his mo de l, la rge de als ,which are common in themarket, might be hard orimpossible to execute, dam-aging liquidity.

Mifir explicitly recognisesthat OTC derivatives mar-kets include relatively illiq-uid contracts, as well asstandardised ones thatlend themselves more easilyto trading on exchanges orformal platforms.

The possibility for opera-tors of venues to arrangetransactions pursuant tot his [ G 20] co mmit ment

New tradingvenues aim toprovide choiceof structures

Europe

Jeremy Grantconsiders keenlyawaited proposalsfor reform

between multiple third par-ties in a discretionary fash-ion should ... be foreseen inorder to improve the condi-t io ns fo r e xecut io n a ndliquidity, Mifir says.

This has been welcomedby the interdealer brokersthat act as intermediariesbetween banks in the trad-ing of OTC derivatives suchas interest rate and creditdefault swaps.

Alex M cDona ld, chief executive of the Wholesale

Markets Brokers Associa-tion, which represents bro-kers in Europe, says: Theinclusion of the proposed[OTF definition] is a vitallyimport a nt a nd w e lco memove by policymakers inEurope , w hich s e nsiblyaddresses the need to pre-serve a variety of executionmethodologies for the vastOTC derivatives market-place and related products.

Yet some question thew isdo m o f cre at ing ye ta not her t ype o f t rading venue, pointing to the com-plexity that has resultedfrom the proliferation ofvenues for cash equities asa result of the original Mifidin 2007.

Damian Carolan, a part-ner at Allen & Overy, a lawfirm, says: Fragmentationo f liquidity a nd pricing sources, which was an unin-t e nde d co nse quence o f Mifid the first time round,must continue to be a con-cern as Mifid II adds yetmore classes of regulatedvenue and applies regulated

trading structures to moremarkets.

Mifir also prohibits opera-tors of OTFs from tradingagainst proprietary capital,which could spell the endfor single dealer plat-fo rms o pe ra t e d by t hebanks, some say.

S t ev e H a ll , h e ad o f E ur op e a nd A si a a tTradeweb, which operateselectronic trading platformsfor fixed income and otherp r od u ct s , p o in t s o u tanother issue: Mifir stipu-lates that all trading ven-ues, including OTFs, shallmake public prices and thedepth of trading interest at

those prices ... on a continu-ous basis during normaltrading hours.

We are concerned that[this] may result in liquid-ity providers choosing notto make markets in certaininstruments or wideningtheir bid-offer spreads so asto price in the risk associ-ated with such informationbeing broadcast, Mr Hallsays.

Both Mifid and Mifir mustnow be passed by the Euro-

pean Parliament, expectedto happen next year. In themeantime US regulatorshave yet to finalise theirdefinition of SEFs. Thatmeans continued uncer-tainty for the market.

Robin Poynder, head ofregulation in the Market-places division of ThomsonReuters, says: With regula-tors on both sides of theAtlantic expressing a desireto align regulation so thattrading across jurisdictionsis straightforward, one canhope that any apparent dif-ferences in approach thatappear within the draft leg-islation will be ironed out.

European Commissionregulations are expected to

be passed by the Parliamentnext year Dreamstime

The final proposalsare marked by

a single policyobjective: forcingmore transparencyon markets

The main message wehearing from the industhat they should be lefdecide how to trade sw


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8 FINANCIAL TIMES FRIDAY NOVEMBER 4 20

ft special report derivatives

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