A number of significant trends have been in place since the Lehman insolvency and the G20 Leaders summit at Pittsburgh in September 2009. The G20 'commitments' to reform the OTC derivatives market have been made real via the Dodd Frank and EMIR regulatory reforms. These regulatory mandates have spelled out significant changes to the market model and the associated market infrastructure.

Executive Summary

• Taking the OTC markets 'all to all' could lead to the high volume prop trading futures market participants accessing the OTC markets
• Leading to IRS spread compression, significant OTC volume increases, large flows into clearing and a re-modelling of the banks FICC businesses from prop to agency service provision 
• Would represent a 'floor to screen' moment for the IDBs and may bring them into play as M&A targets for exchanges
• Clarity of ICE strategy and brilliance in execution puts pressure on peers to respond

Regulatory reforms

• More electronic trading of OTC derivatives to increase transparency and market efficiency. The prescriptive requirements of the OTC trading model are a feature of Dodd Frank but not EMIR. Nevertheless the market assumption has been that a more electronic model for IRS trading in the US is likely to be adopted in Europe as the large investment banks (and their customers) will wish to operate similar models in their major theatres of operations for reason of efficiency and greater operational control.
• Increased use of central counter parties (CCPs) as the preferred approach to the risk management of outstanding derivatives liabilities. Quite simply CCPs are favoured by regulators and governments because they operate a more conservative and transparent risk management model than that operated by the investment banks. Whilst higher collateral requirements arguably increase costs for certain end users, the corollary is a more 'appropriate' collateralisation and one that prevents a collapse of the global financial system as caused by Lehman with the attendant implications for the maintenance of stable democratic political structures and a market model one that more appropriately balances the financial services industry with the rest of the economy
• More transparency in the reporting of OTC (and in Europe listed) derivatives so that exposures are better understood and monitored; i.e. that no institution is allowed to become 'too big to fail' 
• Increased scrutiny and restriction on bank prop trading activities as envisaged under the Volcker rule
• The parallel introduction of Basle 3 has also led to the higher capital requirements for holding OTC derivatives exposures

Development of new models

• Banks are coming to terms with the likely reduction in FICC revenues, more e-trading and higher capital charges as well as the uncertainties associated with the introduction of increased collateralisation and the introduction of LSOC in the US and individual segregated customer account structures under EMIR
• Exchanges are looking at developing new products that reflect elements of the bespoke nature of certain OTC products but also offer the lower capital regime afforded by the futures markets (more on futurisation below) 
• CCPs are preparing for the potential increase in revenues associated with more central clearing but at the same time re-platforming for new account structures, developing new risk algorithms to replace the antiquated SPAN methodology, developing OTC clearing offerings for banks and end customers and, in Europe, going through the far-reaching EMIR re authorisation process
• IDBs are adjusting to lower volumes from their bank customers and lower brokerage fees and the perennial issue of parallel voice and electronic models and the expensive legacy remuneration structures for voice brokers
• Technology providers are adjusting to all the above and the proliferation of new exchanges, markets and platforms in Europe: Gmex, Aquis and NLX to mention just three. The issue of resource prioritisation has never been more profound.

Impact on market structure

• At one end of the spectrum, a 'closed'/restricted access OTC derivatives market with a clear delineation between banks, customers and inter dealer brokers in which high value, low volume, more bespoke products would be negotiated between banks and their customers and then the exposure being managed via (partially) risk offsetting bank to bank transactions or through an inter dealer broker. Although the DF and EMIR reforms require more electronic trading and more central clearing, the fundamental tenets of the model remain unchanged, namely that banks talk to their customers, customers see a restricted view of liquidity and IDBs only talk to banks.
• At the other end of the spectrum sits the futures market. A market characterised by more simple or basic products, 100% electronic trading, multilateral netting and central clearing. An all to all market in which clearing members provide a purely agency service and all end users are market participants, there being no similar segmentation between the role, access and participation of different types of users. A CLOB which has transparent access rules and in which the price is the same to the largest institution or a one lot local.
• Because the assumption has been that this market structure would largely remain in place (despite more electronic trading and CCP utilisation in the OTC markets) there has been an expectation of the potential 'futurisation' of OTC products. The issue being whether exchanges could develop products that exhibited some of the more flexible features of the OTC market whilst at the same time benefitting from the lower capital requirement of a futures contract.

An opening up of the restricted access silo’d OTC market world would…

• Dramatically tighten spreads in the OTC IRS markets as the prop shops trade for much tighter margins than investment banks and are more adept and experienced in high volume, low latency, spread trading. The opportunity to trade the $ and € IRS versus Eurodollar and Euribor futures curves would provide significant new trading opportunities for the futures market day trading firms
• Commensurately reduce the profitability of the investment bank IRS flow desks within the FICC divisions. These desks have been amongst the banks' most profitable businesses in the last 25 years
• Require a fundamental remodelling of the investment bank/client relationship from being a bilateral trading relationship to one of agency or service provision, earning transactional fess for execution and clearing rather than trading profits from dealing spreads
• CCPS could see a huge growth in cleared volumes if the high volume futures players get access to the OTC markets
• It may obviate the need for 'futurisation' type products as IRS spreads become tighter, thereby in part compensating for the higher collateral requirements, which may be further reduced by the concentration of closely correlated OTC and exchange trade derivatives products in a single CCP and then (cross) margined as a single risk pool 
• The development is also likely to have significant impact on technology firms, especially the aggregators. The experience of regulatory change causing multiple liquidity pools (as is the case with the launch of the various SEFs) is very similar to the experience of the equity market in the US and Europe under RegNMS and MiFID. 
• For both brokers/banks and end-customers, there is no desire to connect to the various platforms because of the costs and uncertainty as to which platforms would win the battle of market share. In this environment the role of the 'aggregator' becomes important. The aggregator connects to the various liquidity pools and reflects the various bids and offers onto a single screen; additional functionality can be added with smart routing and order execution functionality. The natural vendors to occupy this space would include ION and Fidessa. ION because of its strong position in the fixed income market and Fidessa because of its market leading role as aggregator on the equity market.
• More broadly there are significant data opportunities as SEFs or OTC platforms open up to new users (data sales and product development)

IDBs in play….?

ICE leads the way

• ICAP – the clear market leader in terms of asset class/product breadth and geographical reach with numerous electronic platforms and other valuable post trade network and compression e-businesses such as Tri-optima, Traiana, Reset etc. The biggest prize but a more complex integration. An ex CME MD now runs the SEF….
• Tullett – good liquidity and flow in fixed income but with a limited electronic offering – potentially a real prize as little legacy technology to retire
• Tradition – reasonable e-commerce offering with Trad-X and Par FX but hard to break into the top three but with strong franchises in certain asset classes
• bgc – sold the e-Speed platform to Nasdaq and a more complex business model
• GFI – traditionally strong in credit with less to lose by being more nimble in moving to the new model (UBS and CSFB already offering DMA into the GFI SEF)

The exchanges

• CME – dominant position in the US market, excellent global distribution, strong position in OTC (IRS) clearing in the US with the cross-margining offering and strong regulatory connections. Limited success of CME Europe offering. ICAP could be their target – with otc flows cleared into their US or European clearing house
• ICE – strategically way ahead of their peers with a peerless culture and excellence in delivery. Numerous clearing houses. ICE acquisition of LIFFE is a game changer and SMX provides an Asian clearing house. They are brilliant but can they manage to digest an IDB without being distracted by the current huge schedule of work?
• DB/Eurex – the M&A hasn't worked for them in recent years and they seem publically committed to organic business development (Gmex, OTC clearing, relaunched Euribor, Regis-TR etc) BUT they will appear even more of a German silo if their peers move. Still need a CCP in the UK.
• LSE – potentially the banks 'champion' and viewed more favourably than the other exchange groups. LCH will be a player. Need to fill the gap in fixed income derivatives. The last remaining London player. Strong links to UK plc. Strength of the MTS business provides opportunity to pull together a very powerful fixed income securities and derivatives offering
• Nasdaq – a rather random collection of businesses needing a stronger derivatives offering. NLX gaining some traction but need to see how volumes develop without ‘paper’ and when the fee holiday ends. Acquisition of e-Speed put them ahead of others, in thinking at least. No credible clearing foothold.
• Hong Kong – big wallet and with the LME in London but no fixed income experience. LME clearing house cannot be made quickly open for IRS clearing
• SGX – evidence of wanting an international element to their business but very limited European footprint