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Futurisation of Swaps & OTC Market Regulation with MIFIR and MIFID II

Hausarbeit 2018 11 Seiten

BWL - Investition und Finanzierung

Leseprobe

Table of contents

1. Introduction

2. Futurisation of swaps
2.1 Advantages
2.1.1 Reduced initial margin
2.1.2 Greater transparency
2.1.3 Lower block size threshold
2.2 Disadvantages
2.2.1 Systemic Risk - the downside of Reduced Initial Margin
2.2.2 Could lower block thresholds potentially harm transparency?
2.2.3 Suboptimal Hedging

3. Regulation of OTC markets

4. Conclusion

1. Introduction

The necessity of increased stabilisation and regulation of financial markets, especially over- the-counter (OTC) markets, has received increased international attention following the financial crisis of 2007-08.1 Previously, swap markets were largely ‘in the dark’ when compared to exchange traded derivatives. The reactionary regulation, the Dodd-Frank Act (CFTC, 2010), has severely tightened the OTC swaps markets through standardisation, increased collateral requirements and reporting standards and a more refined clearing mandate; to continue our analogy, it has sought to bring the swaps market into the light. Due to this increased regulation and subsequent increased costs associated with trading swaps, large swathes of swap trading migrated onto futures exchanges, in a process known as swap futurisation (Smack, 2014). This offered market participants regulatory certainty as well as a reduction in some of the more onerous costs and requirements under the Dodd-Frank Act.

With eight years of trading under the Dodd-Frank regulation, our investigation into the advantages and disadvantages of swap futurisation will focus on trends seen in American data. Following on we will look more closely at the European Union’s response, namely the Markets in Financial Instruments Directive II (MiFID II) and the Markets in Financial Instruments Regulation (MiFIR).

2. Futurisation of swaps

2.1 Advantages

2.1.1 Reduced initial margin

Margin collateral requirements for cleared swaps and futures, used to protect traders against counterparty credit risk, generally come in two forms: variation margin and initial margin (Smack, 2014). In terms of futures, variation margin is usually based on a one-day charge as a function of the variance in the transactional value from the previous day. Cleared swaps also have to post initial margin to cover the potential future risk exposure. Specifically, the amount of initial margin charged and the liquidation period will vary for different types of cleared swaps, from as much as five days with the exception of some commodities swaps (Gensler, 2012). The use of futures will tie up less collateral in margin accounts that can be put to use generating income elsewhere.

2.1.2 Greater transparency

A notable characteristic of swap markets before Dodd-Frank was their extreme opacity. Traders had to call a number of dealers and find the best quoted price, with this information never being publicly available (Gensler, 2012). In contrast, the well-established futures exchanges provide a stable environment for market participants, which means all futures contract transaction data must be reported to the public by the end of each trading day under the requirements of Commodity Exchange Act (Rosenberg and Massari, 2013). Furthermore, the cooperation between futures exchanges and market data service firms also provides real-time transaction data, which further reduces the futures markets’ uncertainty and allows participants to obtain the best-quoted price.

2.1.3 Lower block size threshold

The leaking of market liquidity could be the primary cost of increasing transparency and it could happen in both cleared swaps and futures markets. To resolve the problems brought by transparency, both products allow for a time delay to report the transaction data when reaching a required threshold. As such, this mechanism enables large and/or illiquid trades to be traded in a bilateral manner, preventing predatory traders from learning the trading strategies of their competitors. Swap trades usually have relatively high minimum block requirements (Aditya, 2013). The situation is not equivalent in futures trading markets, however, where there are several minimum trading requirements in the different designated contract market (DCM). The inconsistent minimum block trading thresholds result in the futures markets having a cost advantage in block trading.

2.2 Disadvantages

2.2.1 Systemic Risk - the downside of reducing margin requirements

Regulation of the swaps market has introduced much stricter margin requirements (DeCovny, 2013). The larger amount of collateral and longer holding period (five days) has pushed swaps traders towards ‘cheaper’ alternatives in the futures market (less collateral held for one day). This increases systemic risk from a potential lack of collateral in place should the market suffer a negative exogenous shock. Moreover, by centrally clearing all of this trading volume there is a funnelling effect on the clearing houses. Kaminski (2013) writes that one of the largest concerns cited by opponents of swap futurisation is the creation of central clearing entities that become ‘too big to fail’ as a larger percentage of volume is concentrated on only a few clearing houses. This is highlighted by Toledo (2015) as he notes that the US Government has ‘designated larger futures clearing houses as systematically important’. This designation is a clear sign of the importance these clearing houses have in the post Dodd-Frank financial ecosystem.

2.2.2 Could lower block thresholds potentially harm transparency?

Toledo’s (2015) scathing analysis of swaps futurisation purports their creation as an attempt to bypass regulation to maximise profits, reproducing the risks Dodd-Frank sought to eliminate. One of the central aims of Dodd-Frank was to increase transparency in the swaps market.

Rhode (2013) notes, however, that the attractive lower block thresholds in the futures markets and ten-minute delay in reporting of block trades are in direct contrast to the regulatory aims. From a market perspective, there is a detrimental effect on the price-discovery mechanism. Price-discovery is the “process and efficiency of prices aggregating information about assets values” (Ye, 2016). It is apparent that by circumventing the block trade regulations in place in the swaps market, pricing information will be slower to filter to the quoted price, negatively impacting traders.

2.2.3 Suboptimal Hedging

The duration of a futures contract is usually standardised to certain time frames. Should a firm hedge a position for a period not exactly matching these periods then there is the risk of leaving themselves exposed. This may lead to an increase in operational costs when using futures contracts to hedge positions (Hahn et al., 2013). Moreover, this problem serves to highlight what is perhaps the most important disadvantage of the futurisation of swaps; basis risk. Basis risk is the situation whereby an underlying asset used to hedge against a derivative is imperfectly correlated (Zhang et al., 2017). This will, following price movements, lead to exaggerated gains or losses on the hedged position. Basis risk in the swap market is minimised due to the high customisation available to market participants. This customisation is lost when swaps are replaced with swap futures, resulting in a higher likelihood of suboptimal hedging strategies.

3. Regulation of OTC markets

The year prior to the financial crisis, the EU already implemented the Markets in Financial Instruments Directive I (MiFID I). This directive left OTC trades largely unregulated, with only a single mention in the publication under article 53 (European Union, 2004). Thus, OTC transactions were exempt from pre-trade transparency requirements and there was no publication of trade volume or size. As a result of this opacity in combination with their high market share of around 40% (Gomber et al., 2015), Ferrarini and Saguato (2013) argue that the financial crisis hit OTC markets more severely, highlighting regulatory gaps.

The first milestone and major factor for regulators to implement changes was the Group of Twenty (G20) meeting in September 2009 where member states agreed on a reform agenda to improve transparency and mitigate risk of OTC transactions, especially with regards to OTC traded derivatives (G20 Research Group, 2009). Since this meeting, wide ranging regulatory reform has been implemented across the key derivatives markets of the United Kingdom (Springbett, 2015), Europe (ESMA, 2014), the United States (ISDA, 2014) and Asia (ISDA, 2016). Focusing on Europe, the EU formed a working group which drafted three legal documents: the European Market Infrastructure Regulation (EMIR), MiFID II and MiFIR.

EMIR was implemented in 2012 with the main objective of enhancing systemic stability, with all eligible OTC trades becoming subject to clearing through a central counterparty clearing house (CCP) (ESMA, 2014). By increasing settlement of OTC derivatives transactions through clearing houses (FSB, 2010), the financial system’s exposure to CCPs has become more pronounced (Rahman, 2015), emphasised by the fact that settlement in OTC derivatives is limited to 17 firms in the EU (ESMA, 2017). This is key when considering the threat of counterparty risk, as market participants are exposed to a greater number of counterparties due to reduced choice between CCPs. Kress (2011) provides support to this notion by stating that risk becomes concentrated in CCPs and may only be alleviated by access to central bank liquidity.

The second change was that eligible OTC transactions were subject to mandatory reporting. Both clearing houses and counterparties are obliged to report all transaction details within one working day to a registered trade repository, who make the information available to the European Securities and Markets Authority (ESMA) (European Union, 2012). According to Ferrarini and Saguato (2013), the objective of these changes is to reduce counterparty risk and increase transparency. However, the authors argue that given the number of exceptions to clearing and reporting, combined with the narrow definition of eligibility in article 4 and 5 of EMIR, there was still room for improvement.

MiFID II and MiFIR were published in 2014 in order to close the gaps of MiFID I and EMIR. The aim was to create more safe, efficient, responsible and transparent financial markets (Gomber et al., 2015). The most significant modification under MiFID II was the introduction of a new category of trading venue, the organised trading facility (OTFs), which is added to regulated markets and multilateral trading facilities defined under MiFID I. The OTF serves as a multilateral trading medium that financial counterparties are required to trade through when settling a variety of financial instrument contracts, set out in article 4, paragraph 23 of MiFID II (European Union, 2014a). Francioni and Schwartz (2017) detail that through expanding trading obligations and introducing the OTF, trading will move on to regulated trading facilities barring contracts meeting exemption criteria. According to Busch (2017) and Lannoo (2017), standardised OTC transactions fall within scope of the OTF. This fulfils the G20 agreement to move standardised OTC trading to regulated exchanges should the derivative market in question be sufficiently liquid and eligible for clearing, full criteria available under MiFIR article 25 (European Union, 2014b).

Gomber et al. (2015) further argue that the increase in the volume of exchange-traded financial instruments results in more transparent markets, as a result of regulation extended through MiFIR with greater pre-trade and post-trade information available to participants. This means that pre-trade bid and offer prices have to be made public, along with post-trade information on prices, volumes and transaction times (European Union, 2014b). According to Ferrarini and Saguato (2013), improved clarity leads to optimisation of transaction costs, with Busch (2017) finding that regulation concerning the concentration of trading introduced in MiFID II promotes liquidity and supports accurate price formation.

An additional improvement on previous regulation is specified in MiFIR article 28 (European Union, 2014b), which includes provisions for ESMA to continuously review derivatives trading as a control measure against any class of contract that could result in systematic risk. The ongoing review of developments in derivatives markets offers safeguarding against any unforeseen significant changes to the market structure.

Moreover, MiFIR article 5 serves to curb the extent to which financial institutions can utilise dark pools by introducing a mechanism to cap the volume of trading going through a given venue. Limiting the use of dark pools serves to reduce the advantages available to institutional investors as outlined by Buti, Rindi and Werner (2011), simultaneously reducing information asymmetries caused by their use and restoring confidence to private investors in accordance with article 4 of MiFIR (European Union, 2014b).

Van Lelyveld (2017) argues that the introduction of trade repositories has brought greater transparency to derivatives markets, resulting in dark markets becoming less opaque. Alongside the proposed changes under MiFID II, these markets will be brought closer in line with the reporting standards of regulated exchanges, improving the availability of information to all participants on financial exchanges.

4. Conclusion

Swap futurisation appears to be a means of circumventing regulation in order to mitigate costs and continue realising the huge profits associated with the swaps market. The back and forth between increased regulation and subsequent market reactionary manoeuvres is a natural consequence of efficient capital markets. At $633 trillion, the swaps market eclipses the futures market almost 27 times over (Rosenberg and Massari, 2013), so any regulation must be fair to participants whilst protecting the system at large. In our opinion, swap futurisation is a positive reaction to regulation that is not clear enough in its convictions. As noted in Rosenberg and Massari (2013), overly burdensome regulation has a negative impact, discouraging overall beneficial transactions.

The proposed regulatory changes under the MiFID II directive address a number of the shortcomings in OTC markets left exposed under MiFID I. The futurisation of swaps in the United States details a shift in derivatives trading from unregulated OTC platforms to regulated exchanges, bringing transparency for market participants.

Due to the scope and impact of MiFID II there have been numerous delays in implementing the regulation across all of the intended areas. Once all of the detailed regulation is in place, with all market participants being compliant, only then can we determine the success of the MiFID II directive and its influence on European financial markets.

[...]


1 See Wymeersch (2010); Gomber and Pierron (2010); Morgan (2012)

Details

Seiten
11
Jahr
2018
ISBN (eBook)
9783668776579
ISBN (Buch)
9783668776586
Sprache
Englisch
Katalognummer
v437647
Institution / Hochschule
University of Strathclyde – Business School
Note
1,0
Schlagworte
Swaps Futurisation of Swaps Futures Financial Instruments OTC over the counter financial regulation OTC regulation MIFIR MIFID II MIFID Dodd-Frank clearing Dark trading

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Titel: Futurisation of Swaps & OTC Market Regulation with MIFIR and MIFID II