FRAGMENTATION & CONSOLIDATION.
Hirander Misra, CEO of newcomer Global Markets Exchange Group (GMEX) debates whether new derivatives regulations will fragment markets or make them more transparent, and which venues will play to win?
As a result of new regulations such as Dodd-Frank in the US and MiFID II/EMIR in Europe, we are seeing the migration of many OTC derivatives products
e.g. Interest Rates Swaps (“IRS”) to an exchange type environment as the industry continues to adapt to meet the G20-led market reforms. This is intended to reduce systemic risk by moving over-the-counter, bi-laterally managed derivatives to transparent electronic trading venues supported by central counterparty (“CCP”) clearing houses.
One may argue that this is the start of one of the most disruptive eras in the history of electronic trading we have seen, given the scope of regulatory change, as firms struggle to comply. In such chaos, therein lies the opportunity as business models have to be adapted, with some saying the inter dealer brokers (“IDBs”) have to become more like exchanges and the exchanges more like the IDBs. Nonetheless I would contend the right answer is somewhere in-between.
New trading venues are already being established in this space and at the time of writing 17 Swap Execution Facilities (“SEFs”) had already registered in the US. This is set to increase further and the trend will manifest itself in Europe when the new regulations come into force, be they registered as Multilateral Trading Facilities (“MTFs”) or Organised Trading Facilities (“OTFs”). This is simply far too many to survive, no matter how large the swap market, as the vast majority simply automate what was a manual process without any value add. Those which are run by firms who already have liquidity stand a better chance but even so need to find ways to differentiate their business models in an increasingly constrained regulatory environment.
We saw fragmentation and then consolidation play out in the equities markets, which were already electronic whereas, in this case, an opaque market is becoming more transparent without any steps in between. It is early days, but nonetheless this has also led to some buyside firms trading over the telephone rather than electronically in the short term, therefore having the unintended consequence of reducing transparency, although things will settle down. SEF consolidators who aggregate venues and data will also assist in the virtual consolidation process ahead of any actual consolidation.
Whilst the SEFs fight it out, the real opportunity lies in equivalent IRS based futures products, which can be less balance- and margin-intensive. There will be additional new venues leading on from those such as Eris Exchange, established in the US in 2010, but not anywhere near the magnitude of SEFs because creating a derivatives variant for an underlying “plain vanilla” IRS is not an easy task. These are also supplemented with existing exchange players looking to diversify beyond their traditional product base or geography, such as NASDAQ NLX in Europe, which is live, and CME looking to establish a European-based exchange during 2013, initially trading FX products and then looking to potentially leverage its US rates offering in Europe. TrueEx in the US, whilst live with its SEF elements, will in its capacity as a Direct Contract Market (“DCM”) also launch an IRS futures product.
What is true of most of these products including NYSE Swapnote, which was established in 2002, is that they are based on similar contract structures to each other with expiry dates. At Global Markets Exchange Group (GMEX), we have opted for a different approach with our non-expiring IRS Constant Maturity Future (“CMF”), tied back to the underlying IRS market at the start and end of day by way of an index, which subject to regulatory approval will be launched during the first half of 2014. We reflect the price as an interest rate swap rate rather than all other IRS futures out there, which reflect it as a price.
Also unlike other IRS futures contracts, the instrument allows the ability to trade the whole curve, making it an ideal buy- and sellside instrument for hedging interest rate exposure.
Time will tell how the dynamics between the SEFs and the futures products plays out and indeed in so far as the competition within these two categories is concerned. One thing is clear, in this era of dramatic change, simplicity and low cost must now be the watchwords of financial markets, enabled by innovative products, underpinned by good scalable multi-asset technology. Let the battle commence!©Best Execution 2013