As Europe starts its big drive for transparency in derivatives trading with MiFID II, its first victim is set to be competition.
For trading venues, the hefty fixed costs MiFID II introduces for pre- and post-trade compliance will be a struggle for smaller brokers to meet. It may force some to drop out and others to consolidate.
The larger over-the-counter derivatives traders have been here before. For any venue with US operations, the run-up to MiFID II will have kindled memories of a huge deadline arriving too soon. The Dodd-Frank Act’s forcing of OTC trading on to swap execution facilities in 2013 foreshadowed MiFID II’s drive towards organised trading facilities. Both have left market participants struggling with mountains of compliance.
But as with many of the great regulatory pushes in post-2008 derivatives markets, the difference between a clear-cut US and opaque Europe has been stark.
Global rules on variation margin last year demonstrated the contrast. US authorities can give market-wide regulatory relief using no-action letters — essentially, declarations that firms will not be prosecuted if they fail to comply with a certain law for a certain period. In Europe, regulators say they will judge compliance on a case by case basis, while publicly proclaiming harsh deadlines. This leaves market participants less sure of their ground.
Europe’s strict taskmasters
That contrast looks set to play out again with OTC derivative trading’s move to venues.
“We had more clarity and time under Dodd-Frank than MiFID II,” says Dan Marcus, global head of strategy and business development at Tradition, the Swiss interdealer broker, in London. “Where there wasn’t clarity under Dodd-Frank there was no-action relief in many cases.”
A hundred and fifty no-action relief letters were issued in 2012-13, and over 350 have been issued to date. For over two years, venues operated with no approved rulebooks because of uncertainty about whether they could comply with implemented rules and the Commodity Futures Trading Commission’s inability to formally approve a SEF as registered prior to launch.
“It worked,” says Marcus. “No-action relief under Dodd-Frank was the saving grace for trading venues. Unfortunately, MiFID II is a directive that has been transposed into national law of member states and therefore does not have the flexibility afforded by a body like the CFTC.”
In the US, many exemptions to Dodd-Frank still apply, neutralising regulation that, in retrospect, was not pragmatic to implement. “We don’t have that option under European regulation,” says Marcus. “Whilst there has been some level of comfort from FCA speeches there has still been a lot of uncertainty in the build-up to MiFID II.
“MiFID II has been a heavier and more painful lift than Dodd-Frank,” Marcus concludes. “But at least we have had some decent preparation for this from our experience in the US.”
As it stands, MiFID II’s ultimate costs will be too much for many to bear. The expense of compliance is “nightmarish”, according to one expert. Unless regulators amend the reform, the number of brokers and platform providers operating in Europe is set to decrease. MiFID II specialists predict that only the largest firms and the odd boutique will be able to pay the fixed costs imposed.
To avoid that scenario, European regulators would have to work more explicitly for a level playing field. As well as adopting a form of no-action letter, which European regulatory chiefs have recognised the importance of and even made moves towards for smaller OTC traders’ clearing obligations, there are other lessons US history can teach.
“Because the number of SEFs and Major Swap Participants totals only about 100, US regulators clearly understood the varying levels of preparedness for ‘Title VII’ at the outset of Dodd-Frank,” says Alex McDonald, CEO of the European Venues and Intermediaries Association* in London. “In order to keep a competitive landscape, venue operators were each provisionally licenced to operate. These same firms were then fully authorised sequentially over the ensuing two years, which meant that the incumbents or early movers didn’t gain any advantage from the process.
“Under MiFID II, however, a formal approach has been adopted, which can only serve to entrench the silos and the incumbents at the expense of the small and the new. This is contradictory to the open access spirit of the directive, which was intended to create innovation and competition.”
Death of the American Dream
Despite the more flexible approach of its regulators, the US trading landscape does not look much changed, five years on from the SEF revolution.
Back then, new entrants such as Tera Group, Javelin Capital Markets and TrueEX were readying electronic trading platforms to compete in the interest rate swaps market. But in 2018, TrueEX is the only one still in the game.
Tera and Javelin are now waging a competition suit against major investment banks, accusing 11 swap dealers of having conspired to boycott and block business flowing to their venues, to preserve the dealers’ own profitability in the market.
Whatever the outcome of the case, the interest rate swaps market is evidently a harsh environment for newcomers, even with regulatory support.
In the pre-dawn of MiFID II, there has not even been any start-up excitement for any kind of derivatives, of the kind that attended the launch of Dodd-Frank.
“The derivatives business is a pretty complex construct, from an end-to-end workflow perspective,” says Enrico Bruni, head of Europe and Asia business at Tradeweb, the bond and derivative trading platform. “The scope of instruments that can be traded is extensive, and establishing connectivity to clearing houses or clearing brokers means you have to build an intense network. The new regulatory environment makes this expensive to implement, and new entrants may find it challenging to create those networks. As the cost of compliance increases, the majority of business could migrate to the larger platforms.”
Not all doom and gloom
While MiFID II is unlikely to entice start-ups to unleash competition among OTC trading venues, there is optimism that it will raise standards among the incumbents.
“The regulatory standard required to be a broker will be substantially higher,” says Neil Treloar, director of strategy and business development and MiFID II SME programme manager at Tradition in London. “This will no doubt be good for the market and the quality of execution, but the cost of achieving greater regulatory compliance is so high that the playing field will likely narrow as a consequence, potentially benefiting the larger players.”
Brian Oliver is head of Europe and Asia FICC sales and relationship management at Citadel Securities, the fixed income and equity market maker. He believes MiFID II will significantly boost investors’ access to liquidity, even without new entrants.
“Once fully implemented, MiFID II will allow investors to access new sources of liquidity in an easier and more efficient way,” says Oliver. “Similar to the SEF regime in the US, once clients have joined an MTF or OTF [organised trading facility], they will be able to trade cleared derivatives with all liquidity providers without any further on-boarding or documentation. If they see a price on screen that they want to trade on they can do so immediately.
“This is a big leap for the market and one that has the potential to lower execution costs significantly for end investors, much like the SEF regime has in the US.”
Oliver adds that MiFID II will unlock distribution capabilities for incumbent regional banks in a way that was not doable in the US. That means institutions such as Scandinavian banks that are best of class in their core currency markets being able to open business lines to a wider client base than before.
The regulatory boost will come for second tier players, he argues.
As standards of transparency rise for incumbents such as brokers, banks and platforms, there is also ripe terrain for innovation at those firms. While the electronic effect of MiFID II will principally fall on pre- and post-trade transparency, this may be the seed for innovation elsewhere in their activities, such as in the business of trading itself.
“Different trading methodologies are likely to increase over time, such as volume matching and RFQ [request for quote],” says Jeremy Venables, head of trading technology at TP ICAP, the interdealer broker, in London. “It’s not just about the trend towards electronic order books.
“That will naturally change the way our brokers deal with clients and platforms. Likely there will be less physical voice trading and more physical execution on platforms and dealing via instant messenger, but in a hybrid manner. Technology is already creating the ability to capture voice information and transpose that electronically. That could be very useful for MiFID II transparency requirements.”
For Sunil Hirani, CEO of TrueEX in New York, the path to digitalisation is clear, even if there are bumps on the way. The last remaining SEF new entrant plans to expand aggressively into the rates market.
“The use of electronic trading will increase, not just in Europe but globally,” says Hirani. “And the bifurcation between fixed income instruments that can or cannot trade electronically will continue to create opportunities for us to add value to our dealer and buy-side clients.”
* The Wholesale Markets Brokers’ Association changed its name to the European Venues and Intermediaries Association on December 20, after the initial publication of this story. The article has been changed to reflect this.