By Andy Ross, CEO, CurveGlobal
The shockwaves of the deepest financial crisis in living memory are still reverberating globally. Ten years on, however, lessons have been learned and we are witnessing a significant shift in market behaviour, driven in large part by the implementation of rigorous new regulation.
Despite understandable complaints from customers about new regulation – higher costs, more cumbersome operations, additional paperwork – one apparent result of new rules is an increase in transparency. This is not just limited to what has been executed but, under the new MiFID II requirement for best execution, it also extends to greater visibility as to how and where business is executed.
It is my belief that all the information needed to comply with new regulatory requirements, as well as the information the new rules generate, will spur innovation. As happened previously in the equities, foreign exchange and fixed income spaces, the best execution standard is spawning more efficient and creative ways to measure and analyse transactions for futures, with new businesses dedicated to providing these services becoming increasingly relevant.
Inevitably, as has happened in other areas, the regulatory requirement for greater transparency – coupled with the innovation that follows – leads to a greater participation in trading overall.
As CEO of a new competitor in the futures space I hear considerable grumbling about the new rules, typically from clearing firms and trading firms. Many, however, don’t mention that execution and clearing costs under the old system were continually rising, which adversely affected the users of futures, including institutional investors.
‘Winner-takes-all’ hurts clients
Put simply, the route to both best execution, as well as greater volume, is not achieved through other venues adopting a winner-takes-all approach but by healthy competition, as is the case in many other areas – especially for over-the-counter (OTC) instruments, such as fixed income and interest rate swaps.
In these cases, no single platform achieves more than 50% of total volume traded; and a choice in platforms has kept pricing competitive, while pre- and post-trade transparency has benefited clients in a controlled but impactful way.
Without competition price quality and best execution usually deteriorates. Put another way, the answer for best price or best liquidity for futures trade execution lies not in users electing to use one venue or another but in their being able to take advantage of all trading platforms that compete against each other and innovate to gain volume.
In the futures market, it’s not surprising that other platforms seek to maintain their flow. Unlike virtually all other major financial sectors, the futures space has remained relatively unchanged for decades. Renewed competition promulgated by new venues will promote competitive pricing, more transparency and client-driven innovation. New entrants bring fresh approaches to attract order flow. Innovation, therefore, ignites competition and the result is better execution for clients across platforms.
Competition among trading platforms, of course, raises the issue of best execution increasing the complexity of position management. For example, market participants don’t want to open a position on one exchange if that trade would close out an existing position on another exchange. Of course, two positions can be held until expiry, and the maths to determine whether that makes sense is relatively easy. But if the costs of maintaining the two positions are too high, one could argue that it would be less expensive to consolidate the trades through a single trading venue.
A better solution is to use the innovative tools that have been spurred, at least in part, by regulation, to take advantage of customer choice. The technological tools to manage marketplace choices – combined order books, price checking and position management, for example – are available in Smart Order Routers built into in-house systems and, perhaps more importantly, from a number of software vendors (see Fig 1).
In the wake of the LIBOR scandal, benchmark reference rates have come under intense scrutiny. Regulators globally are striving to improve their resilience and effectiveness, restore credibility and ultimately meet the needs of users in the interest rate futures markets.
The focus on benchmark reform is proving to be another significant driver of competitive innovation. In the UK, for example, there has been growing endorsement and adoption by market participants of the Bank of England’s reformed Sterling Over Night Index Average (SONIA*), an alternative, risk-free rate that is set to replace LIBOR by the end of 2021.
This has generated significant interest in SONIA futures, and in the swaps market there has been over 100% growth (year to date) on LCH-cleared GBP swaps with a SONIA underlying rate to more than GBP 32 trillion notional outstanding (as of August 2018). This marks a fundamental shift in the market and highlights a growing trend over the past decade for increased clearing of OTC derivatives.
Early adoption of the SONIA benchmark will help reduce any potential instability when LIBOR is changed (or discontinued) after 2021, but the key to a smooth, orderly transition to the new benchmark is the ability to hedge risk effectively. Eliminate the legging risk when trading the futures spread against SONIA, with simultaneous fills in the underlying futures contracts, is one way to do this but participants now also have the choice of trading via exchange or OTC.
And the winner is…
With MiFID II not even a year old, the requirement for best execution is only likely to increase, as the need to analyse multiple pools of liquidity over multiple venues grows. As with anything new, participants often ask themselves whether all the complexity is worth it. If we look at the experience in foreign exchange, T-bonds and equities, it’s clear that the answer is a resounding “yes,” in terms of both economics and the fiduciary duty of investment professionals to their clients.
Change is never easy, but putting customers’ interests should be at the centre of everyone’s efforts – which, in the case of futures, now translates into generating better execution. This leads to the question, can regulation be a spur to greater efficiency and innovation? As a dyed-in-the-wool free-marketeer, it pains me to say that – sometimes – it does.