IOSCO's Roadmap to Swap Trading Platforms Discusses Alternative Approaches to the Trading Mandate
Jonathan D. Gupta | Bloomberg Law
IOSCO, Follow-On Analysis to the Report on Trading of OTC Derivatives (Jan. 17, 2012)
The International Organization of Securities Commissions (IOSCO) published a report on the types of trading platforms available for executing over-the-counter (OTC) derivatives transactions. IOSCO highlighted different approaches used by global regulators to mandate the use of organized trading platforms and presented the models currently available, as a way of assisting regulators in developing their respective derivatives trading proposals.
Different Platform Models for Different Products
In its February 2011 Report on Trading of OTC Derivatives (2011 Report), IOSCO asserted that it is appropriate for standardized and liquid derivatives to be traded on exchanges or electronic trading platforms, provided there is a flexible approach to identifying the range of qualifying platforms. The 2011 Report listed several characteristics of qualifying platforms, including:
In the 2011 Report, IOSCO observed that there is a direct relationship between a given platform’s level of structure and the liquidity of derivatives appropriate to trade on that platform. Specifically, structured platforms such as those using limit order books (LOBs)1 or continuous auction systems may be appropriate for more liquid derivatives.
Assessing Market Intelligence
IOSCO collected market intelligence on the current use of platforms as compared against the criteria in the 2011 Report. Generally, trading platforms in IOSCO member jurisdictions fall into two broad categories: multi-dealer platforms; and single-dealer platforms. The two categories may differ in trade execution models, participant and product coverage, degree of automation, and geographic coverage.
— Multi-Dealer Platforms
IOSCO explained that multi-dealer trading platforms fall into two sub-categories: those involving anonymous counterparties; and those with disclosed counterparties. The former are generally hosted by inter-dealer brokers. Prior to trade execution, parties to a given transaction are anonymous to one another. Following execution, the parties are revealed to one another only. These multi-dealer platforms can employ three types of execution methods, comprised of (1) fully-electronic order book trading, (2) hybrid voice/electronic trading, or (3) periodic auction trading.
By contrast, multi-dealer platforms where counterparties are disclosed are primarily used in the dealer-client space, where participants are pre-approved as clients of dealers. Trading interest is initiated by clients requesting firm price quotes from dealers. The identity of clients is fully disclosed to the relevant dealers, and vice versa. Two types of execution method apply, namely request-for-quote or request-for-stream.
— Single-Dealer Platforms
As the name suggests, single-dealer platforms involve only one dealer standing ready to supply liquidity for clients’ derivatives transactions. All such platforms use a disclosed counterparty approach and are either dealer or third party-hosted. Dealer-hosted websites provide access to pre-approved clients, typically including non-dealer banks, hedge funds, and corporations. Single-dealer platforms are often the only type of electronic platform available to participants in some jurisdictions to execute OTC derivatives.
A majority of transactions on dealer-hosted platforms are executed using a click-to-trade execution method, whereby a live bid and offer for a given product is displayed, allowing a participant to click to accept the bid/offer, or to make small adjustments (such as to the transaction date or size), which the dealer may then choose to accept. Alternatively, a request-for-quote or request-for-stream execution method may be used. Dealers may also have trading screens on third-party information networks for use by pre-approved clients. Products offered here tend to be a sub-set of those offered on the dealer-hosted web page. Third-party platforms also allow viewing of quotes for similar instruments from multiple dealers.
IOSCO’s overview of multi-dealer and single-dealer platforms is summarized here:
Platform Features and Functionality
IOSCO compared trading platforms based on features and functionality, such as the range of products traded, transparency, and resilience.
— Products Traded and Customizability
Liquidity and standardization (both legal and operational)2 are primary determinants of the types of products offered by trading platforms, according to IOSCO. In general, single-dealer platforms offer a wider range of products, perhaps given that a single dealer is the sole competitor for quotes, creating an environment conducive to offering new products. Since OTC derivatives are often used to hedge specific underlying exposures, market participants often seek execution venues that provide flexibility to trade customized contracts. Again, single-dealer platforms tend to offer a higher degree of contract customizability than multi-dealer platforms, and third-party-hosted single-dealer platforms usually offer less customization than ones hosted directly by the dealer.
— Pre- and Post-Trade Price Transparency
Pre-trade transparency3 varies widely among trading platforms, IOSCO noted. Those using an LOB execution method provide a high degree of pre-trade transparency. Participants in request-for-quote platforms receive limited transparency, in the form of dealer responses to their requests. Dealers on request-for-stream platforms provide quotes representing firm commitments to buy and sell, but these quotes are generally limited to a select client tier. Post-trade transparency4 is generally very limited for OTC derivatives. IOSCO noted that some jurisdictions are looking for ways to improve this transparency.
— “Resilience” of Operations and Liquidity
Platforms use a wide range of technologies to achieve operational resilience, or the ability to handle a disruption to business operations. IOSCO did not identify material differences in the ability of single and multi-dealer platforms to provide such resilience. As to the impact of extreme market stress on liquidity at trading platforms, IOSCO identified two key factors that may affect “liquidity resilience.” The first is whether the counterparty was known prior to trade execution.5 The second is whether the transaction involved voice negotiation. IOSCO noted, however, that it is currently difficult to predict in advance which trading model would be more resilient in stressed market conditions, given the market’s relative lack of prior experience with swaps being executed on trading platforms.
Anticipated Regulatory Approach
IOSCO noted that some trading platforms—such as single-dealer platforms—would not satisfy the definition of “swap execution facility” under the Dodd-Frank Wall Street Reform and Consumer Protection Act and a related rule proposal by the Commodity Futures Trading Commission, requiring that multiple participants be provided the ability to accept bids or offers also made by multiple participants. By contrast, the European Commission’s proposed Regulation on Markets in Financial Instruments (MiFIR) would require derivatives subject to the trading obligation to be traded only on regulated markets, multilateral trading facilities, organized trading facilities (OTFs), and certain third country markets. OTFs are a new category of trading venue in which multiple third-party buying and selling interests are able to interact in a way that results in a transaction. MiFIR, as proposed, would allow the OTF discretion over execution method.
1 A limit order refers to an order to buy or sell a derivative below or above a specific price. A participant on an LOB platform can execute against the best existing bid or offer, or may place its own firm bid or offer on the book.
2 Legal standardization refers to the commonality of product and contract terms. Operational standardization refers to agreement as to trade processing and related procedures during a trade’s lifecycle.
3 Pre-trade transparency refers to the ability of market participants to see information regarding a swap (specifically, bid and offer prices) prior to trade execution.
4 Post-trade transparency refers to transparency for participants other than executing parties after a trade takes place, including price and volume information.
5 For instance, liquidity providers whose identities are disclosed may have reputational risk in displaying unrealistic pricing during stressed market conditions.
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