The Future of OTC Trading

In order to look ahead, we must first take a look back and examine how OTC markets have evolved; some of which was voluntarily undertaken, most of which was regulatory
July 13, 2016 - Editor
Category: Regulation

In order to look ahead, we must first take a look back and examine how OTC markets have evolved; some of which was voluntarily undertaken, most of which was regulatory reform driven.  

In order to look ahead, we must first take a look back and examine how OTC markets have evolved; some of which was voluntarily undertaken, most of which was regulatory reform driven.  

The dealer has been at the epicenter of OTC derivative trading for decades.  And whilst the Volker Rule and Dodd-Frank in North America and EMIR in Europe aimed at reigning in dealers’ profiles in OTC and other institutional markets, if that were the namesake regulations sole mission they have failed miserably.  Let’s be clear, I’m writing this from a neutral perspective and market observer and am neither a proponent nor opponent of disintermediating dealers from OTC derivative markets; I’m saying it simply hasn’t occurred as regulation intended. Its true new participants have entered the FX and IRS space in liquidity providing roles but others, aspiring new participants (BONY & STT) and legacy market makers (Nomura) have dropped out. New, ‘futurized’ products have been introduced as well with most not gaining in popularity or traction. So let’s be clear, tier 1 dealers controlled the market pre-2008 Financial crisis and control the market today.

The biggest changes have occurred in execution venue and practice.  Since the late 1990s, numerous attempts, most notably by the interdealer broker community were made to introduce electronic execution medium into the traditional voice brokerage model; which likely would have paved the way for buy-side induction which likely is the reason they were never embraced until made mandatory. 

Clearing too has reshaped infrastructure from an IT, human resource, capital, risk and cost perspective. In certain products such as IRS, the competitive landscape has gotten more robust while in others like CDS, competition has been reduced.  Costs have increased across the board, margining has become formalized for cleared product and punitive for bilaterally executed product while credit and counterpart risk has been reshaped and not reduced; another shortcoming of regulatory reform. 

So we can now visually witness bid/ask spreads widen 1000% on the most liquid credit derivative instrument in the world on a SEF (as we did in August 2015) as opposed to seeing it on an indicative run, market dynamics remain much the same.  During times of heightened volatility, due to gross shortfalls of regulation in some areas and negligent market impairment in others, liquidity on SEFs is retracted via wider bid/ask spreads and reduced notionals.

And during times of market stability, liquidity providers have refrained from offering large size and tight spreads particularly on platforms offering anonymity; a futures market infrastructure caveat which the CFTC opted to not impose upon OTC markets.  The theme of regulation going too far and regulation not going far enough is an incredibly important one and this theme is what’s likely to drive the future of OTC derivative trading globally.  But make no mistake, OTC derivative regulation as a function of market evolution has risen faster and grown more complex than the United States National Debt.

So we have bifurcation across markets.  We have markets experiencing liquidity impairment.  We have new entrants attempting to disintermediate the dealer.  We have multiple SEFs.  We have an OTC marketplace overlaid onto a futures market infrastructure.  We’ve reshaped counterpart risk but not reduced it when normalizing for volume.  We have legacy participants that have either exited markets, are in the process of exiting markets or are contemplating their exit.  We have regulations in conflict (you must clear said Dodd-Frank but we’ll make the cost of capital so expensive you can’t clear said Basel III). 

It sure sounds like a mess.  But here’s where I think we’re headed.

We’re beginning to see signs of regulator recognition that multiple aspects of reform have impacted markets negatively.  After all, market participants were forced to consume, digest and process what was two decades worth of reform in less than 2 years.  It’s true that there are compliance schedules for participants but at the end of the day between Basel II & III, the Volker Rule, EMIR and Dodd-Frank, it’s just too much for the market to handle and globally coordinate at once.  My conclusion, we’ll likely see revisions and reconsiderations to numerous aspects of regulation which maintain market stability (at least in regulators eye) but relax other covenants; most importantly to OTC markets and clearing would be applying common sense to leverage ratio requirements.

In terms of electronic execution, RFQ or anonymous order book requirements might go the way of the Dodo.  These provisions have worked from a procedural perspective and nothing more at a time in which there has been virtually zero market distress, volatility or interest rate due to global monetary policy.  As the FOMC is on the cusp of normalizing, and rates gradually increase along with the follow through effect to supply and demand imbalances, a multiple pre-trade quote requirement will only hurt liquidity and times when it’s needed most.  I expect we’ll see consolidation amongst execution venue disruptors and an increase in hybrid solutions that pair traditional voice/messaging execution with electronic medium.  Clearing is likely here to stay until a member defaults which I’d assign a probability to within the next 5 years which is higher for certain products (CDS at 63%) than others (IRS). 

In conclusion, nothing has changed and everything has changed.  Market dynamics and our state within the credit cycle will warrant changes that post 2008-Financial Crisis regulatory reform has induced.  Impacting this significantly will be the upcoming Presidential election in the United States; which has a strong stench of policy party allegiance with most Democratic contenders wanting to further ‘strengthen’ Dodd-Frank while Republicans want to address its impact in the form of significant revisions and/or unwind. 

Capital intelligence at the front office and treasury level will play an increasing role in guiding OTC markets as we move closer to Basel III implementation.  And unless embraced by the dealer community, future-ized OTC product will largely remain just that.  The hope for significant increases in market participation across new participant demographics will continue to be dim unless regulators and CCPs adopt OTC derivative margin requirements which resemble the futures market.  There is one thing I’m absolutely certain of – the impact of ‘regulatory reform’ has been mostly able to hide behind uber-accomodative monetary policy. 

We got a very small taste of how regulatory reformed institutional markets respond to volatility in August 2015 and it wasn’t pretty; and that was incredibly short-lived.  We need common sense regulation which strengthens our global financial infrastructure, not weakens or conflicts with itself.  There are issues which need to be addressed and remedied which have been borne out of post-2008 Financial crisis and OTC derivative market reform which have been allowed to fester behind the sanctity of a zero rate environment and if not addressed, we’ll have traded three systemically important defaults for forty.

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