This is the second in our series of weekly blog posts on the topic of over-the-counter (OTC) derivatives reform.
Until now, the vast majority of OTC derivatives trading has been conducted by broker dealers on a bilateral basis via voice execution, with rather infrequent use of electronic platforms. While this might mean that clients receive a customised service, the voice trading model leaves much to be desired when it comes to transparency.
But under the new rules agreed by G20 leaders in a bid to increase transparency and reduce systemic risk in the derivatives market, OTC standardised derivatives must be traded on multi-dealer electronic platforms. While this move to ‘electronification’ is mandatory for all jurisdictions, national regulators are approaching it in different ways. We explore this topic more in our whitepaper, “Understanding the New OTC Derivatives Landscape”.
Global Picture Not Yet Complete
According to the Financial Stability Board (FSB), as at November 2014, just three jurisdictions had regulations in place that required organised platform trading: China, Indonesia, and the U.S.. The rest were still working on the legislative frameworks required to enact the necessary regulation at a local level. Little surprise, then, that the U.S. model has been used as a ‘template’ by some other regions, notably the European Union. Nevertheless, differences do exist between the two regimes:
- In the U.S., electronification rules came into effect on 15 February, 2014 for Interest Rate Derivatives, and on 26 February, 2014 for Credit Default Swaps (CDS). Therefore, all (cleared) standardised OTC derivatives must now be traded on Swap Execution Facilities (SEFs) as mandated by the Commodity Futures Trading Commission (CFTC).
- In Europe, there are comparable SEF rules for “Organised Trading Facilities” (OTFs), as part of the Markets in Financial Instruments Directive (MiFID II/MiFIR) that was approved on 15 April, 2014 - although actual implementation will not occur until 3 January, 2017. These rules introduce a trading obligation for standardised derivatives which are eligible for clearing under the European Market Infrastructure Regulation (EMIR).
Importantly, the European legislation differs from the U.S. rules on asset class coverage. In addition to derivatives, it introduces a market structure framework for other non-equity instruments such as bonds and structured products. These will also have to be traded on OTFs, marking a significant change in the way financial instruments are traded.
Reaping The Rewards
As the E.U. and U.S. continue to cooperate, and regulators in the Asia-Pacific region finalise their approach to electronification according to the Financial Stability Board, it is inevitable that teething problems will occur in the near-term. But there are many long-term positives that will emerge from this change as well: electronic trading should increase pre-trade price transparency, reduce information asymmetries in the market, and boost liquidity.
Moreover, with trade information being made available to all market participants, this should mean that the price discovery process is improved. According to Deutsche Bank, the monitoring of positions and exposures should also become easier, given that price information will be automatically captured in databases – in real-time (in the U.S.). In Europe the timing of reporting is different: Derivatives transactions must be reported within one business day of the date they are executed. These benefits will only increase as electronification gains momentum.
Read more about the impact of electronification and how the OTC derivatives market will operate under a new infrastructure in our latest whitepaper, “Understanding the New OTC Derivatives Landscape”. You can also read our first blog in this series, “Central Clearing Begins To Bite”.