Over-the-counter (OTC) derivatives have soaked up more than their fair share of criticism for the financial crisis. Given the size of the markets, that may not be surprising. But while OTC derivatives were not a central cause of the problems faced over the past 18 months, it’s a prudent time to strengthen the infrastructure of the market. Increasing transparency and oversight will not only provide greater protection to institutional investors but will shield the industry from further blame in the future.
The New York Fed earlier this year outlined a number of ways for improving OTC market transparency and efficiency, one of which was through the use of electronic trading platforms. I agree with the sentiments of the Fed, but it is important that the details of the legislation reflect the intent behind them.
Electronic trading platforms will register as (alternative) swap execution platforms (SEF) under pending regulations but the definition of a SEF needs to be informed and precise enough to ensure that it has the desired impact on market structure.
At the heart of the market reform is the need for greater price transparency to investors. SEFs can provide the framework for a competitive electronic marketplace in which institutions can most easily access the competitive pricing across a broad range of dealers. In its paper, the Fed argues that “for sufficiently liquid transactions - which represent most of the interest rate swap market – electronic trading platforms offer more transparency and competition than available through privately-negotiated transactions.”
Pre-trade transparency can provide participants an accurate picture of where the market is trading in real-time. Electronic trading is ideally suited to provide this level of price dissemination, enabling institutional investors to get a more reliable and broad-based understanding of market opportunities. This higher level of confidence can lead to increased trading activity and a higher level of price competition between the sell-side market participants.
Post-trade transparency can further add to the ability of regulators and investors to monitor markets, but there are dangers. Talk of a system similar to the NASD’s TRACE reporting system for U.S. corporate bonds sounds reasonable, but regulators will want to be careful. If derivatives traders are forced to disclose trades too quickly after execution, it could easily damage rather than enhance liquidity. Hedging large positions is not always easy for sell-side traders, especially if competitors are aware of the size and direction of a trade just entered into.
Central clearing is a more clear-cut issue and the market is moving rapidly to implement more efficient post-trade processing solutions.
The protagonists in the discussion around derivatives legislation generally seem to be moving in the right direction, but the swaps markets have been running by their own rules for many years and change will not come overnight. There will be resistance from some, but the end-game is becoming clearer to most people.
The OTC derivatives market is one of the world’s last remaining hold-outs from widespread electronic trading. Some of this is due to reluctance to change what has been a highly successful marketplace for both buy-side and sell-side but it is still a sector where great benefits will materialize for institutional investors when reform is passed. The current process, including the signing of ISDA agreements, credit checking and confirmation processing, is cumbersome. The crafting of language around the definition of SEFs and other legislation underway can seem arcane, but there is a lot at stake. Get it right and institutional investors can look forward to a more even playing field, with greater price transparency and more efficient markets. Move in the wrong direction and not much will really have changed over the past 18 months. And that, at the very least, would be a missed opportunity.
