The unintended consequences of new rules for fixed income and OTC derivatives markets could create chaos, industry experts warned at last week’s TradeTech Europe event.
Two session on the final day of the conference dissected the implications of the new for the buy-side, the sell-side and trading venues.
In OTC derivatives, new rules that are due to be implemented at the end of this year will require standardisation of instruments where possible to enable trading on exchange-like platforms and centralised risk management via clearing houses. Complex or exotic instruments will be subject to higher capital charges.
While acknowledging that the rule will make the swaps market safer after the, Anthony Belchambers, CEO of trade body the Futures and Options Association, said there is a danger that the costs could outweigh the benefits.
“We are reaching a tipping point,” said Belchambers. “There are still questions around what clearing will actually cost, how liquidity in these markets will react and what the market consequences will be.”
One particular consequence that has been at the forefront of market participants’ minds lately is the issue of collateral, with the new clearing obligations requiring more high-quality, liquid assets to be posted at central counterparties to cover initial and variation margin requirements. Belchambers stressed that currently, demand is far outstripping supply, with non-financial users of derivatives that don’t typically hold such assets being particularly affected. The International Monetary Fund has said US$300 billion worth of new collateral will be required when the new rules come into force.
Looking at how exchanges are tackling the challenge, Hans-Ole Jochumsen, president at Nasdaq OMX Nordic, said improvement of technology was a key consideration.
“We are preparing for more algorithmic and high-frequency trading in the swaps market,” said Jochumsen.
The speed at which the regulation will come into force in Europe was also a concern. Clarity on the level one text for the European market infrastructure regulation (Emir), the key legislation driving OTC derivatives reform in the region, was only received in February. The detailed level two technical standards are scheduled to be unveiled by the European Securities and Markets Authority in October, leaving firms with little time to prepare for compliance.
“The political pressure to push the new rules through is huge but anyone who thinks we will meet the implementation date is barking mad,” said Belchambers. “All firms need to think about implementation and compliance of the new rules now, as this pressure will only build.”
Session moderator Alex McDonald, CEO of the Wholesale Markets Brokers’ Association, then asked panellists about the redrawing of accepted boundaries between the OTC and listed derivatives markets and how this might shape the market in the years to come.
Belchambers cautioned that the OTC market should be seen as complementary to the listed market and that the blurring of the two could lead to an “appalling” outcome.
“The OTC market has historically been the breeding ground for new types of contracts,” he said. “If/when contracts grow in the OTC space, exchanges then pluck them out. Exchanges have a mixed track record on the launching of new contracts.” Belchambers added that exchanges have previously listed new contracts that were perfectly eligible for CCP clearing but found to be unsuitable for multilateral execution.
Asset class mismatch
Reforms to the fixed income market will have similarly wide-ranging consequences to existing trading models, with Carl James, head of fixed income trading at BNP Paribas Investment Partners, anticipating “chaos” if policy makers are too rigid in their attempts to impose equity-like structures in fixed income.
In addition to MiFID II, the main driver for fixed income reform in Europe, banks need to be wary of Basel III and the US Dodd-Frank Act’s Volcker rule, which will limit their ability to control bond pricing and facilitate fixed income trading for the buy-side as they have done historically.
But panellists were quick to note the differences in the liquidity profiles of fixed income instruments compared to equities, which present substantial barriers to the application of common market structure principles. The large majority of bonds are thinly traded because they are held until maturity, compared to equities, which are traded hundreds of times a day.
“Transferring equity constructs to the fixed income market is a mistake,” asserted James. “Fixed income is simply a headline for an asset class, unlike equities.”
Of particular concern were proposals for tighter pre- and post-trade transparency regimes for bond trades, which are practically non-existent under current practices in Europe.
On the pre-trade side, as well as the thinly traded nature of fixed income instruments, speakers noted the desire from regulators for retail and institutional traders to have access to the same quote information, arguing that wholesale and retail bond markets had different needs, as in other industries.
“Post-trade transparency will offer some much-needed visibility of the fixed income market for the buy-side,” said James. “However, MiFID II will create greater fragmentation of liquidity through the new structures of trading venue that are created, so making conclusions based on this data could be impossible.”