Apr 19, 2018

New Forces Impacting E-Trading of OTC Derivatives

When we look at the derivatives market today, we see several trends delivering impactful change. Two in particular—MiFID II and trading technology innovationare propelling two main phenomena: an increasing placement of exotic derivatives onto electronic platforms and advancing competition from a new kind of entrant into the market.

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In this blog, Numerix Chief Marketing Officer James Jockle interviews Robert Gray, Vice President at Numerix and an OTC derivatives market expert, to gain insight into these forces that are starting to transform the derivatives market.

Electronification of exotics . . .
James Jockle: Electronification appears to have its greatest strength in the fixed income markets, but we are now seeing it become prevalent across structured and exotic derivative products. What are the drivers?

Robert Gray: Fixed income was early in going electronic. It lent itself well to electronification because, as a low margin, low latency, high volume vanilla business, it made commercial sense. But it also must be noted that the technology at first did not have the capabilities of handling the challenges presented by exotics.

However, driven by recent trading technology advancements and increasingly elusive profitability, market participants are moving more complex structures onto electronic platforms. Furthermore, the growing demand for innovative derivatives to hedge portfolio risk is also driving the move to electronification as a result of significant increases in trade volumes and quotes.

Another key factor is that trading through electronic platforms has surged since MiFID II came into force on January 3 of this year, and exotics are in the scope of MiFID II. MiFID II pushes for transparency, efficiency and less risks and so one immediate result of this legislation is that it kindled a rise in electronic trading as market participants flocked to electronic platforms to meet the new rules.

MiFID II’s impact on OTC market . . .
Jockle: Speaking of MiFID II, do you believe this regulation will benefit the OTC derivatives market?

Gray: OTC derivatives trading has improved dramatically, becoming safer and more efficient because of regulatory reforms, and particularly now with MiFID II in place. For example, today the OTC market provides significant pre-trade transparency and price-discovery mechanisms. Additionally, in terms of post-trade transparency, issues such as trade reporting and clearing are addressed, which means OTC derivatives are becoming more “exchange like” in their structure, resulting in less credit, market and operational risk, as well as smaller collateralization costs. All of this is good for the OTC business.

Jockle: MiFID II came into play in Europe, what are your views on how this legislation may ultimately play out in the U.S.?

Gray: It’s already playing out. When a trade in the U.S is done with a European organization, that trade still needs to comply with MiFID II. This applies to all global jurisdictions. There may also be an element of voluntary adoption from financial institutions, such as insurance firms, that are not subject to MiFID II but who are looking to replicate best practice. If there is a best execution rule that is good for one, then you could argue that it is good for everybody.

New technology brings new competitors . . .
Jockle: We are now seeing that commercial access to new trading technologies means new competitors are entering the market, particularly non-bank liquidity providers. Do you think this is going to become a real challenge to the traditional market maker, the investment bank?

Gray: I think it will, eventually. The non-bank market makers, players such as Citadel and Virtu, are providing extra liquidity—deeply and consistently—into OTC products, liquidity which was previously the preserve of the top tier banks. Some of these non-bank competitors, which also includes hedge funds, were born out of the old prop trading desks that dissolved when the Volker Rule essentially banned banks from engaging in proprietary trading. These non-bank market makers have a lot of talented ex-bank traders, quants, and e-techies working for them, so they are already very experienced with the markets. They are also more than capable of migrating into complex products, such as exotics.

Technology plays a huge role in the competitiveness of the non-bank market makers. Through tech vendors, they are investing in faster, more optimal technology that delivers advanced real-time pricing and analytics, and which more effectively manage risk. This type of technology was once only the purview of large institutions such as JPMorgan, Goldman Sachs and Bank of America, who had the sizable budgets required to build in-house platforms with event-driven, real-time market capabilities.

The new technology allows the non-bank market makers to “get in the game” right away. While they are not eating anyone’s lunch yet, they are starting to take bites of market share. For example, according to a Greenwich Associates report, currently one in five government bond investors and one in four interest-rate derivative investors either trade with or plan to gain access to non-bank liquidity providers.

Speed matters . . .
Jockle: What would you say is the single greatest barrier for success in the OTC derivatives market?

Gray: It is really all about the technology. Let’s take speed for example. If a dealer is on a multi-dealer platform, unless that dealer is among the first institutions to give a price on a trade, then it will be too late to win the trade. It won’t matter even if it has the best price. Speed of price is a very helpful differentiator. And I’m not talking about responding with a price in seconds, I’m talking about responding with a price in a fraction of a single second. That’s a capability found with today’s next generation technology, and it plays a significant role in building a true flow business.

Robert Gray is an OTC derivatives market expert at Numerix and a long-time industry veteran in the space. His career began in LIFFE, trading for ten years in futures and options for Lehman, SGF (now ICAP) and Tullett, in addition to a brief stint on the IPE trading Brent Crude Oil. Following the end of pit trading, Mr. Gray began a sales career with roles at Standard and Poor’s, SuperDerivatives, Saxo Bank and CMC Markets across EMEA. Just prior to joining Numerix, Mr. Gray spearheaded an OTC derivatives pricing and RFQ solution for a traditionally back office-focused software company. He is currently a sales manager for Numerix’s EMEA territory.

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