Over-the-counter market eyes revolutionary road ahead
13 Dec 2010
The over-the-counter derivatives industry is set to end 2010 very much as it has spent most of the year: waiting for the next regulatory pronouncement.
In the US, the Commodity Futures Trading Commission met on December 9 to consider proposed rules under the Dodd-Frank Act, including, among other things, the requirements for swap execution
facilities and end-user exceptions to mandatory clearing. Meanwhile, in Europe, the markets have begun the Mifid II consultation.
Far from being rendered redundant and derailed by the financial crisis, Mifid II has been redirected and expanded, much in the custom of European regulatory gambits. Perish the thought that
European regulators would admit they got it wrong and start again.
The consultation paper suggests that the Mifid framework be reworked to require that all standardised derivatives that are eligible for clearing be executed on an electronic platform such as an
exchange or multilateral trading facility. In this respect, it follows closely the principles established in Washington, DC.
At the moment, of course, no one knows what constitutes a standardised derivative or, still less, what will qualify as a swap execution facility or multilateral trading facility.
It is to be hoped that the next few days and weeks will bring much-needed clarity to these topics because, make no mistake, this is the way the industry is being forced to head, and both banks and
brokers face enormous reorganisation and investment to redesign the operation of OTC derivatives to suit the demands of regulators.
At the end of last month, a foretaste of things to come was provided by Tradeweb, the online trading platform that made its name in the government bond markets. It became the first US trading
venue on which a fully electronic swap transaction was executed and then cleared by a central counterparty. The trade was a two-year dollar interest-rate swap, the dealer involved Deutsche Bank (with
an unnamed end-user) and it was cleared on LCH.Clearnet.
This event followed the first electronically executed and cleared interest-rate swap in Europe in late September. As has been the case throughout the development of electronic dealing of OTC
derivatives, the US has lagged Europe. But in neither continent is electronic trading of swaps the norm; far from it.
It is estimated that perhaps only 10%-15% of dealer-to-customer trades are executed electronically, and only a little more dealer-to-dealer.
Tradeweb has executed about $1.25 trillion of interest-rate swaps this year and Bloomberg perhaps the same. These two institutions dominate electronic trading of interest-rate swaps, yet they
account for only a fraction of the overall market.
Brokers Icap and BCG have also launched electronic trading systems in the past couple of months, but the bulk of their trading is still conducted on the phone. “Electronic trading is still in its
infancy, particularly dealer-to-customer trading,” said a senior professional in this business last week.
All this is set to change, and quickly. The speed with which the futures market shifted to an electronic model is a useful example. Over the course of a couple of years, the entire industry
forsook open outcry, and the wonderful live theatre of futures brokers wearing colourful jackets became as much a part of financial history as ticker tape and the three-Martini lunch. And the futures
industry didn’t have a regulatory boot behind it either.
Existing online swaps trading facilities such as Tradeweb and Bloomberg are set to do well out of this sea change in trading practice. Their systems are already in place and it would be extremely
surprising if regulators in the US and Europe did not designate them acceptable swap execution facilities.
It seems less certain that the banks’ own customer dealing platforms will be so designated as well. The banks would clearly prefer to use their own proprietary systems, but those close to
regulatory discussion suggest that single-dealer platforms will not be acceptable as swap execution facilities as they do not, by definition, provide a range of prices to customers.
By this time next year, much greater understanding of what regulators want will exist – hopefully – and building will be under way. The OTC derivatives industry will be in the middle of the
biggest changes it has experienced in the 30 or so years since the first interest rate swaps were written.
This is not to say, however, that voice dealing and the traditional opaque way of doing things will die out. For a variety of illiquid markets, this remains the best way of offsetting
Take the case, for example, of a US borrower pricing a large sterling denominated bond, say £500m, at 10 years and wishing to swap the proceeds back into fixed dollars. This swap would involve
three legs – a sterling interest rate swap to take fixed to floating, a cable basis swap to take floating sterling to floating dollars and a dollar interest rate swap to take floating dollars to
The final leg of this package of transactions could probably be executed on a swap execution facility without undue trouble. But the sterling interest rate and basis swap markets are notoriously
illiquid: attempting to push through a trade of that size through a swap execution facility would send prices running for cover. The syndicate managers handling the swap would much rather contact a
preferred broker on the phone, and let the swaps be pushed out carefully, bit by bit, into the market. This is probably the way that the market will continue to operate when illiquid instruments are
But, for everything else, a revolution beckons next year, and most of this year has been spent getting used to that uncomfortable idea.