Fears for Future of More Complex OTC Instruments as Regulations Begin to Bite

Terry Flanagan

Some market participants are worried that the push towards greater electronification in fixed income markets will lead to some of the more esoteric instruments becoming abandoned.

Regulations in response to the global financial crisis, such as the Dodd-Frank Act in the U.S. and MiFID II and Emir in Europe, are accelerating this trend away from the more opaque world of OTC trading towards a more transparent model that is aimed at reducing systemic risk. While innovation in technology has also played its part in this shift, with some market participants envisaging a day when fixed income securities are traded on open exchanges in a similar way to stocks.

The aim of the regulators on both sides of the Atlantic is to push all standardized contracts on to exchange-like venues and through centralized clearing, in accordance with G20 commitments by the end of this year, although some of the more complex products will have to remain OTC instruments—although they will be burdened by more stringent margin requirements—as they remain too reliant on human intervention.

However, there seem to be more questions than answers from some market users as to how this move to electronic trading in fixed income will be achieved. In some fixed income markets, such as government bonds, electronic trading is now around 50% but in markets like swaps, the figure is only about 10%.

“The complexity of some instruments that are not standardized cannot be translated from a voice conversation or a Bloomberg message into a structured message that can be transmitted from A to B that can be transacted or reported as a trade,” said an executive from a European brokerage.

“That almost looks insurmountable. A lot of practitioners are doing a lot of soul-searching. A lot of the dealers are saying that this is just too much and we will just not play this game. In FX and in derivatives we have had algo trading for quite some time. But in interest rates, credit derivatives and fixed income generally we are still behind. It is in progress, but it is a very disruptive time.”

However, many banks and exchanges are looking to capitalize on this move away from OTC trades in fixed income and exploit the rich pickings that have traditionally been on offer to the big dealer banks who act as middlemen for the buy-side investors who wish to buy and sell bonds.

One of the more recent to unveil its plans has been Deutsche Börse, Germany’s largest stock exchange, which last week announced that it was planning pre-empt legislation, such as MiFID II, which is expected to become law in 2015, to boost liquidity and transparency in the fixed income market with the addition of bonds to its Xetra electronic order book.

Xetra, which is Deutsche Börse’s cash market, will, from October 1, offer trading in more than 2,000 government and corporate bonds and 60 German government bonds. Deutsche Börse says that trading participants will also gain access to a broad investor network via Xetra.

“We already meet the transparency requirements of the revised MiFID financial market regulations which will be mandatory in two to three years’ time,” said Rainer Riess, managing director of Xetra market development at Deutsche Börse.

“Exchange trading always means transparent pricing. However, a large number of government and corporate bonds are still traded OTC—with a lack of transparency, high risks and unclear prices for trading participants and investors. Xetra Bonds is a pan-European bond trading model with high transparency and binding quotes; designated sponsors and specialists provide high liquidity—so all market participants profit equally.”

Deutsche Börse says that for the first time, the open Xetra order book will have a depth of five price levels, showing the five best bid and ask limits and the market data dissemination will offer trading participants complete transparency in pre and post trading. The bonds will also be settled by Eurex Clearing, the exchange’s clearing house.

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