OTC Harmony Proves Elusive

Terry Flanagan

Significant differences emerge between U.S. and Europe on trade execution.

Differences between the emerging regulatory structures for trading OTC derivatives are threatening to undermine the stated G-20 goals of bring greater transparency and reducing systemic risk in swaps.

Although MiFID II and the Dodd-Frank Act share the broad goals of requiring most OTC contract to be centrally executed and cleared, sharp differences exist in how they would bring that about.

“For all the talk about harmonizing regulations, it is not clear at this stage that it is going to be happening,” Jim Rucker, chief operations, credit and risk officer at MarketAxess, told Markets Media.
For example, in the United States, OTC derivatives will need to be traded on either an exchange or a swap execution facility (SEF).

In Europe, under MIFID II, OTC derivatives can be traded on regulated markets, multilateral trading facilities (MTFs), or on a new category of trading venue–organized trading facilities (OTFs).

OTFs would include both bilateral and multilateral systems, capturing all types of organized execution and trading arrangements not captured by regulated markets or MTFs, including broker crossing systems and single-dealer platforms for trading OTC derivatives.

OTF operators under MiFID may not execute any transactions against their own capital [as systematic internalizers] but will have discretion over how a transaction will be executed and may restrict access to clients with whom they don’t want to trade.

An MTF, on the other hand, brings together multiple buying and selling interests in a non-discriminatory way. An MTF may not reject particular members or participants.

“OTFs could include single-dealer crossing networks,” said Rucker. “In this respect, OTFs differ from SEFs, as it does not appear the SEF rules will permit single dealer platforms.”

Operators of SEFs believe that customers should be given the choice of how they want trades to be executed, including the ability to negotiate and execute block trades without having to interact with resting orders.

In the SEC’s proposed rule, if a securities-based SEF operates a central limit order book (CLOB) and a separate RFQ mechanism, then any trade would need to interact with existing interest on the central limit order book at the same or better price before interacting with interest on the RFQ platform.

Market participants are concerned that if a block trade were required to interact with other trading interest on an SB SEF, there might not be  enough liquidity on the SB SEF to execute the entire block trade, leaving a portion of the block trade unexecuted.

“We believe the trading protocols available on MarketAxess, including our RFQ capabilities that are tailored to less liquid markets, are more suitable than a CLOB or exchange model for the type of trading typically done in CDS,” said Rucker.

That said, given the range of liquidity across the CDS market, MarketAxess intends to offer clients a choice in protocols for trading CDS.

“In addition to RFQ trading, we offer live, streaming markets for CDS indices,” said Rucker. “Clients can choose the mode of execution that best meets their trading requirements.”

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