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OTC Derivatives under MiFID II

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One of the major – and possibly one of the most transformative – parts of the MiFID II regulation is the introduction of controls around the OTC market, and specifically how certain asset classes should be traded. Organised Trading Facilities (OTFs) are to be established to capture trades that would otherwise be executed OTC and are designed to increase pre- and post-trade transparency.

While this idea of increased transparency is laudable, the practicalities of implementing and working with such new trading models may prove more difficult and more costly than expected. For example, previously when an OTC trade took place, very little in the way of reporting was needed and post trade activities were already understood. Now, ironically, things are less clear as reporting requirements are being reviewed and more consideration is needed for the post trading arrangements. Where will such trades get reported, by when, and by whom exactly? What post trade models will be adopted? Are such trades getting cleared and where?

The nature of the directive means it has caused significant uncertainty around how it will practically affect the market, only once the regulations are finalised will the initial impact become clear. However, if the creation of MTFs for equities under MiFID I is anything to go by, the full implications will not be understood until well after these regulations come into force and market participants react to them.

Indeed we can use MiFID I as a lens through which to look at the potential future of the markets after the creation of OTFs. MTFs were almost a small-scale test of what is to come with MiFID II. In the wake of MiFID I, MTFs such as Turquoise, ChiX, BATS and others were set up with the aim of lowering transaction costs and increasing liquidity in equity markets. However successful they were at this, it was not the only effect they had on participants or the market.

The increase in the number of venues placed a greater emphasis on the technology needed, highlighted the importance of latency on the network and in systems and the latency race began. Trading times as well as execution size plummeted, variations in pricing across venues were exploited and, as speeds increased the amount of time these pricing anomalies existed for decreased. The impact on clearing requirements, relationships and clearing houses was also profound.

Arguably this race for faster trading speeds and the change in the post trade space would have happened sooner or later – but MiFID I’s introduction of MTFs increased the pace of this change. It’s not a huge leap to suggest that MiFID II’s introduction of OTFs will have effects on the same scale.

The emergence of the synthetic CDO 2.0?

While it’s difficult to speculate what these effects will be, it’s not hard to see the risk of potentially stifling of innovation (and thus revenues) in structured products.

Structured products have sometimes been seen by regulators as “weapons of mass destruction” and as such have been the focus of their ire since 2008. However, the majority are used responsibly and allow participants to express complex views of the market that vanilla products do not have the capability to match.

OTC contracts have been successful in part because they are arranged in private and tailored to the business needs or market views of clients. By bringing these products onto exchange, and making them more transparent structurally, there could be the risk that other parties benefit from someone else’s foresight. This will erode any real incentive to create innovative structures. Another concern would be how to ensure that parties buying such complex structures on exchange really understand the risks involved, akin to the commoditisation of the dreaded synthetic CDO. If the past teaches us anything it’s that new regulations often spawn new things to regulate.

Will OTFs be the new MTFs?

The introduction of MTFs under MiFID I was arguably the lasting legacy of that regulation. It democratised equity markets, trading costs decreased, and technological advances prompted a rapid increase in trading speeds and reduction in overall latency. Under MiFID II, OTFs could do exactly the same thing for non-equity markets. The question is where these OTFs will come from and if their evolution will eventually follow the same path of competition, co-opetition and eventually consolidation?

The MTFs sparked something of a turf war with established exchange; it could be argued that some MTFs were set up expressly to reduce trading costs. Eventually the dust settled with, for example, the LSE buying Turquoise, BATS and ChiX merging, NASDAQ OMX Europe closing and eventually a more open, liquid landscape forming.

There is the potential for the same thing to happen with OTFs. Will participants look for access to multiple OTFs from the start or will they wait to see what the end state is? These questions will have an impact on how far and how fast the OTC market changes.

It’s good to keep talking

It’s clear that moving OTC contracts onto exchange is not without its challenges, and these challenges are exacerbated by the need for complete transparency. This need for transparency involves technological solutions and what these solutions are is another thing to add to the growing list of uncertainties.

Reporting systems will need to be created, both pre- and post-trade. Market access will have to be secured – what’s the best way of connecting to multiple destinations and multiple data feeds, what hosting needs will arise, what other service providers are needed? Will the infrastructure needs be differentiated between cleared and non-cleared transactions?

The exact form of these technology requirements will be shaped by the eventual market structure and the market’s reaction to such a change. In order to be in a position to move efficiently and rapidly when the OTC market starts changing, all participants need to work together to create a new market landscape – both operationally and technologically. It’s only through an open dialogue between service providers and participants that the market will be able to move forwards.

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