Swap Markets Face Uncertainty

Terry Flanagan

Pre-trade transparency requirements too onerous, ISDA says.

The transition from a bilaterally-traded OTC market to an exchange-traded market is hitting some speed bumps.

Market participants are questioning whether regulations will force MTFs to adopt a central limit order book (CLOB) model for OTC derivatives.

Such a model is ill-suited to the less-liquid nature of many OTC swaps transactions.

Nearly all users of OTC derivatives products have relationships with multiple dealers, and two or more dealers are typically put into competition for each deal, providing the client with quotes for the specific

trade that the client wishes to execute, according to the International Swaps and Derivatives Association.

For more liquid OTC derivatives contracts investors have access to many

sources of information displaying the exact price at which they will be able to trade: multilateral platforms offer an order book of dealer prices that clients can trade on, just as single dealer platforms offer firm “click and trade” quotes.

Both single dealer and multilateral platforms also support Request-For-Quote (RFQ) functionality, where an investor sends an RFQ to the dealer, often on the basis of streamed indicative prices from the dealer, then receiving a firm bid/offer with no obligation to trade if the investor is not happy with the price.

MiFIR (Markets in Financial Instruments Regulation) introduces an obligation to trade clearing eligible and sufficiently liquid derivatives contracts on an organized trading facility (OTF), MTF or regulated market.

What is classified as “sufficiently liquid” will be defined by the European Securities and Markets Authority (ESMA) based on average frequency of trades, the average size of trades, and the number and type of active market participants.

MiFIR also requires MTFs and OTFs to make publish prices on a continuous basis. ISDA said it has “significant reservations” with this requirement.

The references to “continuous” quoting and “public prices” presuppose a specific execution method, i.e. trading in a central limit order book environment, said ISDA, which is appropriate only for a deeply liquid market with a high number of participants and simultaneously available matching trading interests.

ISDA recommended that the pre-trade transparency obligation be amended to recognize trading models beyond the CLOB model.

Seeking to impose such a model of transparency on the non-continuous trading that characterizes large segments of the OTC derivatives markets could undermine liquidity in the market by potentially revealing participants’ trading interests, encouraging others to trade

against them, said ISDA.

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