US and European regulators are trying to reduce counterparty credit risk and increase the operational integrity of global markets with proposals to encourage trading on multilateral platforms that could help inject transparency and increase liquidity. Regulators in the US and the European Union are calling for relevant standardised derivatives contracts to be executed on regulated venues and centrally cleared. This would in effect ensure they are traded on a swap execution facility (or SEFs as they are known in the US), regulated multilateral trading venue or an exchange.
Regulators are coming to the conclusion that regulated multilateral trading facilities (MTFs) that can connect end users to multiple dealers offer both pre- and post-trade transparency. For over-the-counter (OTC) derivatives in particular, the EU is focusing on improving pre-trade transparency in order to get better price discovery and post-trade transparency in order to shed light on dangerous exposures or concentrations that may increase systemic risk.
Compared with corresponding rules under the US Dodd-Frank Wall Street Reform and Consumer Protection Act, the current markets in financial instruments directive (MiFID) II proposals in the EU focus less on the trading protocol and more on ensuring there is sufficient transparency through the pre and post-trade process. Changes under MiFID II are likely to have the strongest impact on the OTC equity derivatives market, given that it is larger in Europe than in the US.
There is concern that the current proposals – if they are not properly geared and calibrated according to the characteristics of the relevant market – could compromise the quality and depth of liquidity in the marketplace. For instance, disseminating pre- and post-trade data could increase the cost to dealers of hedging client-originated trades, leading to fewer customised OTC offerings and fewer large transactions.
End users on the buy-side will prefer to avoid giving the market a chance to move against any large orders they want to place. Enforcing complete pre-trade transparency could prompt derivative end users to drip-feed smaller transactions into the market, which would only further reduce liquidity. Electronic trading platforms are well positioned in this regard, offering the flexibility for a potential buyer or seller of a derivative contract to seek a price from a single or multiple market participants.
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