MIFID II: harmonization mandates new business models in the OTC space
When the first iteration of the Markets in Financial Instruments Directive (MiFID) was implemented in November 2007,
it transformed the marketplace for equities. It introduced the concept of multilateral trading facilities (MTFs), and helped to lower transaction costs, narrow bid-ask spreads and accelerate trading times in equity markets, as was envisaged by the European Commission. However, MiFID has also had unintended effects on the market, by increasing market fragmentation through the proliferation of trading venues and the emergence of dark pools..
These two perceived negatives—market fragmentation and dark pools—are addressed with MIFID II, which attempts to bring the positive effects of the equities space to non-share instruments traded over the counter (OTC) by professional investors and responds to the lessons learned from the 2008 financial crisis. In this way, MiFIR / MiFID II should be viewed as the European Union’s premier legislative tool for encouraging the expanded use of market infrastructure and adhering to the 2009 G20 commitments.
Responding to an Integrated OTC and ETD Derivatives Market
The post-reform landscape has wide-ranging implications for both the sell side and the end users of derivative transactions. The trading convention differences between exchange-traded and OTC derivatives are diminishing, as OTC derivatives are moving from a predominantly bilateral model to a more transparent cleared model. In light of the electronification of OTC markets and their convergence with exchange traded derivatives (ETDs), a consolidation of ETD and OTC derivative infrastructures and trading behaviour is likely, as they will be traded on similar exchanges and follow similar processes.
Breakup of Vertical Integration
Execution is expected to shift from dealers to third-party trading venues that will provide greater market transparency, increased instrument standardization and broaden access for investors. Bid-ask spreads are expected to tighten and minimum margin requirements will increase on non-cleared derivatives. In addition, the clearing obligation will reduce bilateral exposures and concentrate counterparty risk in central clearing counterparties (CCPs).
The consequence is that dealers will have to unbundle their services, as electronic execution and clearing are expected to be a smaller part of their value chain. The anticipated proliferation of trading venues, as already begun with SEFs in the US, means that end users will have more opportunity to choose trading venues based on offerings and costs. This is expected to foster competition and lower transaction costs. Pretrade transparency is expected to enable more efficient price formation and reduce informational asymmetries between the buy side and the sell side.
Firms that up until now were offering OTC trading to clients via single dealer platforms will have a reduced execution-only stream of revenue. Under MIFID II / MIFIR, they will need to migrate their trading to OTFs or apply for authorization as systematic internalizers (SIs).
Operators of organized trading facilities (OTFs) will not be able to execute trades on their own account, meaning their business model will be fee-based. Given that all of the SEFs registered with the US CFTC are not operated by an investment bank, firms that want to continue trading principal with clients will need to apply for authorization as an SI. This will require them to exceed specified thresholds in terms of the volumes they deal on a bilateral basis. Therefore, investment firms need to perform a cost benefit analysis of each option: acting as an SI, operating an OTF under a separate legal entity or ceasing trading in these areas.
The Joint Committee of European Banking Supervisors has published principles on product oversight and governance for both investment product manufacturers and distributors (7), while MiFID II has extensive rules for ensuring product suitability, requiring better client data analytics.
Banks can rationalize their product portfolio by tailoring it to meet target customer needs. Carefully selecting the product mix that is provided in-house and the products provided on an agency-only basis can reduce costs and enable bespoke services when needed. Customer centricity predicated on a robust technology infrastructure that uses data analytics for better product design and customer relationship management can unlock value hidden in seemingly competing interests between regulatory, customer and investor demands.
Expansion of Industrialization
As the OTC and ETD market infrastructures converge, derivatives dealers have the opportunity to reduce costs through developing partnerships with market infrastructure providers in order to meet common industry challenges and ensure common standards. A certain level of market collaboration can make strategic and economic sense, especially to alleviate resources devoted to routine back-office activities and free capacity for resources devoted to front-office revenue generation. Sharing costs with other partners can substantially improve the cost to income ratio, and greater industrialization of processes can streamline operations, decreasing reliance of subsidiaries on intragroup shared services. This is especially important for dealers who want to act as an agency business capturing volume, where capturing cost efficiencies passed on to customers is paramount to achieving scale.
Banks must define their future market strategy. Early and conscious action can put an organization in good stead reaping rewards of early positioning. A proactive approach also applied to compliance projects provides early movers with adequate time to develop robust solutions, with ample time available for testing changes. Developing a patchwork infrastructure that is barely fit for purpose can put banks at a steep competitive disadvantage with competitors that have the right infrastructure to support their operating models. Haphazard approaches can also jeopardize the subsequent evolution to a stable business as usual process. This has been strongly underscored by the minimal impact on normal operations and benefits of this approach when offering services such as delegated reporting to clients.
Business Model Considerations
As dominant derivative players become constrained from entering clearing and trading venue markets in the same form as the past, it is imperative for firms to consider their business models, especially in light of the imminent single-dealer platform push-out. As parts of the derivatives trading market are being transformed from a high-risk/high-return enterprise into more volume-driven businesses, some big players are struggling to increase revenue, while others are pushing ahead and embracing change. Existing and new market players will have to compete across three basic dimensions: price, customer service and differentiation.
The three dimensions of emerging derivative models on which investment firms will fiercely compete and disruptions may be imminent are the depth of liquidity they can offer, the breadth of synergistic services they can cross-sell and the level of uniqueness or differentiation they can establish in their propositions. These three characteristics will need to be predicated on a robust operating model that can ensure sustainable operational effectiveness in order to build credibility and facilitate product take-up and client penetration in the market.
- Depth of Liquidity: The investment firm aspires to achieve economies of scale and establish cost leadership by attracting as much customer flow as possible competing on price and breadth of venues.
- Breadth of Services: The investment firm aspires to achieve economies of scope by providing an end-to-end service that offers the maximum level of synergistic value-added services in order to meet the client’s holistic needs and drive cross-selling.
- Niche Focus or Bespoke Customization: The investment firm aspires to differentiate its offering by focusing on specific products, client segments or geographies based on its strengths or relationships, in order to become a credible specialist provider, e.g. specializing in bespoke OTC products with higher margins.
Operating Model Considerations
Ensuring connectivity with key market infrastructures, such as CCPs, and electronic trading venues, such as SEFs and OTFs, will require extensible operational infrastructures and efficiencies. On the pre-trade space, reference counterparty data will need to be extended and cleansed in order to enable smooth client onboarding and compliance with Know your Client (KYC) regulations. Banks will need to select and onboard to electronic trading platforms, which will require the rationalization of existing platform connections that do not offer much benefits relative to costs.
Trade execution will require effective order aggregation and smart routing in order to ensure best execution, while data analytics will play a role in ensuring collateral efficiency through CCP margin calculations based on real-time market prices. Trade capture, confirmation and clearing will require system rationalization across asset classes and products, especially given OTC and ETD convergence. A centralized cross-asset and product agnostic platform can reduce back-office costs by minimizing fragmentation and allowing better enterprise-wide risk data aggregation and reporting. The level of automation needs to increase to capture efficiencies especially for products which currently lag in automation, such as bespoke products and commodity derivatives. In addition, exchange trading will initiate a shift from mark-to-model valuations to mark to market, increasing the importance of reliable market data feeds and group-wide clock synchronization.
Clearing across assets and CCPs to provide netting and end to end service benefits will be the major selling point of one-stop-shop dealers focusing on synergistic derivatives-related capabilities in order to build economies of scope.
The wider adoption of electronic trading of standardized OTC products in order to attain economies of scale in central clearing and trading can help incumbents with broad installed client bases. These firms will try to attract as much client flow as possible, by offering competitive transaction pricing and connectivity with the widest selection of trading venues and CCPs. With the possible emergence of buy-side market makers, an agency-based or sponsored access execution model will rely on processing efficiency to lower unit costs and enable competitive pricing, while aggregating sufficient volume of bids/offers and multiple liquidity providers.
To fully capture the opportunities emerging from financial reforms, market players need to evolve their strategies, reengineer their business models, delineate their differentiated capabilities and build partnerships in order to effectively deal with the fundamental power shift away from dealers. Players who strategically invest in building the required data analytics, increasing operational efficiencies through automation, system consolidation and industrialization, will develop robust technology infrastructures and risk frameworks. These capabilities will allow them to dominate, stay competitive in the new environment and rapidly capture share in the new market.
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