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21 April 2016

TABB: OTC derivatives under MiFID II – Transparency only through collaboration

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One of the major parts of the MiFID II regulation is the introduction of controls around the over-the-counter market, specifically how certain asset classes should be traded.

Organized Trading Facilities (OTFs) are to be established to capture trades that would otherwise be executed OTC and are designed to increase pre- and post-trade transparency. But the practicalities of implementing and working with such new trading models may prove more difficult and more costly than expected.

While the idea of increased transparency is laudable, the practicalities of implementing and working with such new trading models may prove more difficult and more costly than expected. For example, previously, when an OTC trade took place, very little in the way of reporting was needed and post-trade activities were already understood. Now, ironically, things are less clear, as reporting requirements are being reviewed and more consideration is needed for the post-trading arrangements.

The nature of the directive means it has caused significant uncertainty around how it will practically affect the market; only once the regulations are finalized will the initial impact become clear. However, if the creation of MTFs for equities under MiFID I is anything to go by, the full implications will not be understood until well after these regulations come into force and market participants react to them.

OTC contracts have been successful in part because they are arranged in private and tailored to the business needs or market views of clients. By bringing these products onto exchange, and making them more transparent structurally, there could be the risk that other parties benefit from someone else’s foresight. This will erode any real incentive to create innovative structures. Another concern would be how to ensure that parties buying such complex structures on exchange really understand the risks involved, akin to the commoditization of the dreaded synthetic CDO. If the past teaches us anything it’s that new regulations often spawn new things to regulate.

It’s clear that moving OTC contracts onto exchange is not without its challenges, and these challenges are exacerbated by the need for complete transparency. This need for transparency involves technological solutions and what these solutions are is another thing to add to the growing list of uncertainties.

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