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September 21, 2016

The Mirage of All-to-All OTC Trading

Unlimited trading counterparts and “sources of liquidity”; quite a stark contrast from legacy OTC derivative market infrastructure.    

Unlimited trading counterparts and “sources of liquidity”; quite a stark contrast from legacy OTC derivative market infrastructure.

 

If there were two elements of change regulatory reform brought about, anonymous trading via an all to all infrastructure was on the top of all non-dealing buy side participant’s wish list.  This novel concept, which characterizes the futures market for instance, was envisaged to at least partially offset new regulatory induced costs of clearing and formalized margining via compressed bid ask spreads; why go to the messenger when you can go directly to the source.  But while Volker, Dodd-Frank and the maze of Basel rules went too far in instances, perhaps the CFTC failed to go far enough by not imposing an anonymous trading mandate; in my opinion, the most critical requisite for a functional all-to-all OTC derivative infrastructure.

Pre trade limit checks, limited OTC clearing firms and a fear of reprisal via breaking from the status quo are all obstacles which the OTC markets have yet to overcome. Inter-dealer brokers’ efforts have been met with swift and fast resistance as they explore means to offset declining dealer to dealer volumes. Market and technology disrupters have gained little traction in some instances, think Javelin and Trumid. And it can be argued technology service providers have done more to preserve legacy execution infrastructure than disrupt it, think Bloomberg.

All this while market conditions have been incredibly benign.  My fears about gross dislocations and liquidity impairment will be felt when liquidity is needed the most. Regulatory reform curtailed excessive risk positioning across the sell side with the follow through being overall reduced market volume, liquidity and ability to transfer risk via OTC derivative products.  But one needs to look beyond the OTC markets for drivers of derivative volume to grasp where the liquidity will come from when demand increases.  It’s true that new entrants like Citadel and DRW are attempting to pick up legacy dealer slack, but they surely can’t be expected and couldn’t be the singular answer regulatory reformers sought to reshape the OTC derivative marketplace.  We have an unfulfilled void left as a result of regulatory reform which the market has yet to solve for.

If the feeling amongst regulators and participants is more time is needed for evolution, then I think the only thing additional time brings is a reversion to the mean.  We’ll continue to have firms dip an introducing broker toe into the OTC derivative market touting anonymous, all-to-all execution but with numerous platforms splintering volume and legacy dealers not embracing anonymous trading at all or preserving best markets for traditional and name give-up execution venues, a functional all-to-all OTC derivative market will remain just a distant thought.

And the problems extend to buy side as well.  Not a single firm has yet to emerge or voice a willingness to stream or provide consistent liquidity to the OTC market.  While the extent of this varies across products, I’m quite certain it couldn’t have been the intention of regulatory reformers to put legacy market making dealers in the position of soliciting liquidity and pricing from hedge funds for instance; a trend which in fact is going on as we speak.  With minimal incentive for first movers coupled with a gross deviation from core business, perhaps all-to-all OTC infrastructure shouldn’t be characterized by traditional buy side firms getting in the business of providing liquidity.  Trading Deutsche Bank and Morgan Stanley for DRW, Jump, Getco and Citadel isn’t the answer either.  Complimenting legacy infrastructure with new participation on the market making side makes a lot more sense as a mechanism for migrating to an all-to-all infrastructure as opposed to turning off a huge spigot of liquidity and opening a much smaller one.  


This article was first published in edition 7 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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