Verena Ross, Executive Director of ESMA, recently delivered a keynote speech to the ABA/Law Society Capital Markets Conference in London. Her speech focused on the importance of increasing transparency in MiFID II “in a manner that does not 'damage' but instead improves the functioning of the market,” making particular mention of “those instruments, such as derivatives, that are still far from being traded in a fully transparent market.”
At first look, the proposed MiFID II text appears to handle this and realize the G-20 objective of promoting transparency, efficiency and competition in the OTC derivatives markets. The text requires all EU trading venues to have “transparent and non-discriminatory rules, based on objective criteria,” governing access to the facility (Articles 18(3) & 53(1)). However, if we look more closely, and consider the parallel legislation in the US, which has failed to prevent both implicit and explicit barriers to access for OTC derivatives venues, we soon discover that further explicit regulatory action is needed.
The OTC derivatives markets have historically operated as a “two-tier” market: a top tier of inter-dealer trading and a second tier for customers to trade with the group of dealers in the tier above. Inter-dealer trading platforms deny access to all non-dealer market participants, which limits competition and hinders access to best execution. The two-tier structure also reduces the supply of liquidity by preventing alternative liquidity providers from accessing the swap market.
Criteria for access can only be objective (as required by the Articles 18(3) and 53(1)) if they are directly relevant to the system’s operation, and do not simply prevent access to the venue by a given class or category of market participants. Historically, the pretext for the “two-tier” system was the bilateral counterparty credit risk involved in OTC trades, but this has been eliminated with the introduction of central clearing and straight-through-processing (“STP”), meaning this criterion is no longer objective and therefore invalid under MiFID II.
OTC derivatives can be traded in three venue types: regulated markets, MTFs[1] and OTFs.[2] The definitions of regulated markets and MTFs require that they trade under an “all-to-all” market system – in other words any type of market participant (buying or selling) can interact with any other. The current inter-dealer and dealer-to-customer practices inherent in the “two-tier” system are inherently incompatible with this definition.
The OTF definition also requires the same “all-to-all” system of interaction, but has additional freedom to “determine and restrict access based, inter alia, on the roles and obligations which they have in relation to their customers.” This clause is the greatest risk to non-discriminatory access in these venues: without legal safeguards to ensure that OTFs specify access parameters in an open and transparent manner it may be possible for these to be used as a means of continuing discriminatory access, as has happened in the US. Any criteria that exclude and entire class or category of otherwise eligible participants (e.g. non-dealers) either implicitly or explicitly do, by definition, involve discrimination.
The benefits to customers of OTC markets adopting non-discriminatory access are clear: customers would be able to execute trades with any other eligible counterparty, providing access to best execution. By lowering barriers to entry for new liquidity providers, non-discriminatory access would promote competition, minimizing the concentration of risk among too-big-to-fail dealers. As has been seen in the equity markets, this narrows the bid-ask spread, improving the prices that the customers receive.
Overall, these benefits would lead to increased depth and breadth of liquidity, thereby achieving two central goals of MiFID II: increased transparency and safeguarding liquidity. It would also foster the development of a consistent and efficient infrastructure across the EU and US markets. I very much hope that the final text of MiFID II will take into account the lessons already learnt in the US, and will leave no room for the practice of discriminatory access to OTC derivatives trading to continue.
The views expressed in this blog post are the personal opinions of the author and do not necessarily reflect the official policies or positions of the FIA European Principal Traders Association or the Futures Industry Association.
[1] The definitions for both a regulated market and an MTF (multilateral trading facility) refer to a “multilateral system which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments.”
[2] OTF (organised trading facility): A multilateral system which is not a regulated market or an MTF and in which multiple third-party buying and selling interests in … derivatives are able to interact in the system in a way that results in a contract in accordance with the MiFID II framework.
